As global equities have mostly recovered from the first quarter bear market lows, and large cap growth technology stocks have rallied well above the broader market, one could say investor sentiment has reached “euphoric” levels.
This euphoria is partly in response to unprecedented levels of global fiscal spending and monetary support in reaction to the global pandemic-induced shutdowns, as well as hopes for a coronavirus vaccine (several promising candidates are in Stage 3 trials).
Even with corporate and municipal credit spreads widening off the lows over the past week (as long-term U.S. Treasury yields hover near post-COVID low levels), cyclical cross-asset risk is well bid. Investors seem to be betting on a zero-interest-rate regime induced by developed central bank policies, which are unlikely to be reversed anytime soon even if the world experiences a bout of cyclical inflation.
Our own proprietary indicator (Figure 1)—which considers several risk-appetite proxies such as market volatility, breadth, commodities and fixed income (term structure, credit) —has reached relatively high levels.
Keep in mind that our risk appetite indicator is not designed to serve as a trading signal, but to capture a mosaic of investor greed/fear sentiment. And it’s suggesting euphoria.
Figure 1: Risk Appetite At ‘Euphoric’ Risk-Seeking Levels
Sources: Bloomberg, 3D Asset Management
Historically, extreme readings of risk-seeking/risk aversion have led to subsequent market reversals.
Citigroup maintains its own market sentiment indicator (Figure 2), where Haver Analytics overlaid the subsequent one-year forward market returns. High readings such as what we are currently seeing have also historically pointed toward subpar market returns over the subsequent year.
Figure 2: Citigroup Market Sentiment – ‘Euphoric’ Readings Have Historically Led To Subpar Market Returns
Not only are risk appetite indicators tracking at historically “euphoric” levels, most—if not all—of the underlying components signals are either positive or trending well above trough levels. This unusual occurrence suggests that market euphoria has also led to increased cross-asset correlation.
This can be anecdotally observed with the coincident rally in commodities (both industrial and precious metals), long duration risk (premium growth stocks and long maturity bonds) and cyclical risk (cyclicals versus defensive sectors, corporate credit risk).
Regardless of whether the global economy experiences some level of normalization from the COVID-induced shutdowns, investors are at least betting on the willingness of global central banks to maintain negative real rate policies to support and justify ever higher asset valuations.
Momentum’s Defining Moment
The willingness to drive asset valuations higher on negative real interest rates can be observed with the current elevated valuation of “momentum,” as captured by the iShares MSCI USA Momentum ETF (MTUM). Back in June, in our article “Momentum: The Other Second Wave,” we projected the possibility of “momentum” capturing a second wave following its brief early June drawdown.
Not only has momentum made a second-wave comeback, its strong post-COVID run and outperformance of other factors have largely defined this recovery in risk appetite.
Figure 3 displays the forward 12-month price/earnings ratio (top panel) and forward 24-month Bloomberg consensus EPS estimates (bottom panel). For the latter, we chose 24 months to better capture the expected 2021-2022 earnings recovery being modeled by sell-side analysts.
You can see that U.S. momentum, which captures much of the large cap growth technology rally so far this year, is trading at 10-year high valuation levels, even though earnings are not expected to recover to their prior peak levels.
Figure 3: Market Euphoria Captured In US Momentum Trading At 10-Year High Valuation Levels
Source: Bloomberg through 8/21/2020
Built On Thin Air
While we don’t entirely discount the rational outlook for global market recovery, absent any meaningful inflation that would prompt a tightening response from central banks, decreasing market breadth (based on advance/declines) of fewer names along with stock-split announcements of go-go growth stocks suggest that the latest market advances seem to be treading on lesser substance and thinner air.
What to do about all this? We would suggest caution heading into the end of the year. Keep an eye on credit spreads and commodity prices for early signs of risk appetite fatigue and higher market volatility.
At the time of this writing, 3D held positions in MTUM. The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy. It is for informational purposes only. The above statistics, data, anecdotes and opinions of others are assumed to be true and accurate; however, 3D Asset Management does not warrant the accuracy of any of these. There is also no assurance that any of the above is all inclusive or complete.
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