The recent wild swings in stock prices, driven in part by retail investors using low-cost online trading platforms, have been taken by some as another sign of excessive exuberance and froth in the markets.
Our ‘market dynamics’ tools are indeed showing signs of consolidation in major equity markets both in the short and medium term. Over the longer term – through the second half of 2021 – they continue to suggest an uptrend in equities.
Another indicator of stretched positions has been an extremely low put-call ratio as a particularly high number of calls on individual stocks have been purchased. The ratio was closer to normal, however, for stock indices and has since risen, suggesting that the risk is more concentrated in individual stocks (see Exhibit 1).
The effects of concentrated stock risk
That concentrated stock risk was still quickly felt in the broader market last week. As short positions were squeezed, many investors were required to liquidate long positions to cover losses on shorts and to meet margin calls.
This might explain why the returns were unusually similar across different styles and sizes: global large cap, mid cap, small cap, value and growth indices all produced almost identical weekly returns through last Friday (29/01). The relatively poor performance of value indices is also surprising when both Treasury yields, inflation expectations, and oil prices rise over the week.
While options positioning in several parts of the market has been extended , fund flows tell a different story. Recent data is limited, but at least through the third quarter of 2020, flows into equities were close to zero, with modest inflows from retail investors offset by redemptions from institutions. Partial data since then shows continued redemptions from mutual funds and exchange-traded funds (ETFs) (see Exhibit 2).
It is worth noting that over the course of the bull market since March 2009, institutional investors have redeemed over USD 800 billion in equities, while retail investors have invested roughly the same amount. One could ask the question to which group the term ‘smart money’ should apply.
A positive – Strong earnings growth
One of the key supports for our more positive longer-term view is the continued strong growth of US company earnings. With nearly half of the companies in the S&P 500 having reported, earnings growth is admittedly unimpressive on the surface at just +2%. However, after a year in which GDP contracted by 3.5%, this is extraordinary.
Much of the declines in earnings are concentrated in the energy and airline industries due to the collapse in travel. Exclude these two sectors and earnings growth jumps to 12%. Sales have also risen year-on-year for this sub-section of the market by 8%.
These positive numbers contrast with the contraction in earnings expected by analysts. Earnings surprises have been unusually high this quarter (as they were in the second and third quarters last year), running at 17%. Moreover, corporate guidance is running over 45% positive, far higher than the typical 23%.
Beware – Guidance is thin on the ground and stimulus might fall short
Some caution is warranted. Many companies are still reluctant to provide guidance given the manifold uncertainties around the pandemic, vaccines and fiscal stimulus. Only two-thirds as many companies have provided any guidance at all compared to the same quarter a year ago.
The final note of optimism comes from earnings revisions, though this also highlights a risk. Earnings revisions are currently running 2-to-1 positive as analysts factor in the large-scale stimulus envisaged by the Biden administration.
As opposition Republicans in the Senate are proposing a far smaller amount, the increase in earnings that analysts are counting on may not materialise. Alternatively, if the administration uses budget reconciliation to pass the larger package, this could threaten future spending plans on infrastructure or the Green New Deal.
 In our previous Weekly investment update, we observed: “…there are increasingly concerns over a speculative bubble in stocks. Federal Reserve data show that thanks to last year’s strong returns, equities now represent a high share of US household assets”. See Americans are holding a record amount of their portfolios in stocks, surpassing dotcom-bubble levels, JPMorgan says and Households and Nonprofit Organizations; Directly and Indirectly Held Corporate Equities as a Percentage of Total Assets, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/BOGZ1FL153064476Q