Regular readers of my column know that I have a penchant for quoting famous songs that are apropos of current market behavior. Today, rising to the top of my playlist is Stephen Sondheims standard, Send in the Clowns.
The three-ring antics of a new wave of inexperienced traders indicate a dangerous juncture in the markets. When social media gossip creates wild market swings, its time to get wary.
Neophyte investors whose trading decisions are guided by financially illiterate chatter on message boards have been wreaking havoc in the markets. Bored by lockdowns and quarantines, theyre using their stimulus checks to play the stock market like a lottery. This volatile trading is likely to continue as the appetite for risk-on assets gets stronger.
Its not just kids wearing backwards baseball caps, trading in mom’s basement. Billionaire CEOs and Wall Street celebrities are making or erasing billions of dollars in market value, with just a few keystrokes on Twitter.
Dont get me wrong: Im generally bullish over the stock markets prospects in 2021. The economic recovery is accelerating, the job market is improving better than expected, the Federal Reserve has vowed to maintain its accommodative stance, and new fiscal stimulus is probably on the way in the form of President Bidens infrastructure plan.
Economies are re-opening and consumers are in the mood to spend. The latest manufacturing data show that factories are starting to hum again around the world, especially in the global growth engine of China.
However, the emergence of the dumb money is worrying. These are the sorts of investors who run for the exits at the first whiff of bad news, a dynamic that could create a downdraft for the broader market, which hovers at record levels and remains vulnerable to a pullback.
The instant paper wealth generated by meme stocks, despite their poor underlying fundamentals, is a contrarian indicator. Hype on financial television encourages the recklessness.
Watch This Video: GameStop and the Investor Insurrection
I expect the CBOE Volatility Index (VIX), aka “fear gauge,” to rise in coming months, as anxious investors grapple with an admixture of optimism and fear. Stay invested but stay on your toes. Below, Ill show you strategic moves that can generate growth but also keep your portfolio on an even keel when the markets get choppy.
Another record week
Stocks hit new record highs last week, as the bull market keeps chugging along. U.S. and global equities are in positive territory year-to-date (see table).
High consumer savings, widespread vaccine distribution, and Bidens ambitious spending plans will likely create a Goldilocks condition for investors replete with sustained growth and tame inflation.
Nonetheless, you should hedge your portfolio against the risk of temporary sell-offs. The quickening pace of vaccination is encouraging but the coronavirus pandemic hasnt gone away. New variants of COVID-19 are popping up that concern health experts. Unexpectedly bad news about the virus could send highly valued stocks into a temporary tailspin.
There are a growing number of red flags that the bull market is overheating, with indicators of investor risk-taking reaching the highest levels since the fateful years of 2007 and 1999.
According to data from the Financial Industry Regulatory Authority, by the end of February investors already had leveraged their portfolios with borrowed money to the tune of $814 billion, a record number. That’s a 49% year-over-year increase, the largest jump since 2007. The previous high was during the dot-com bubble in 1999. The following chart shows the sharp rise in leverage:
Over the past four months alone, margin debt has surged by $154 billion, a record increase that has helped push equities to historic highs.
Super-investor Bill Hwang last month lost about $20 billion in two days when his Archegos Capital Management hedge fund collapsed because of highly leveraged bets on tech stocks. The turmoil still reverberates, as big banks get hit with multi-billion-dollar losses.
Stock valuations are getting frothy. According to research firm FactSet, the forward 12-month price-to-earnings (P/E) ratio for the S&P 500 is 22.4. This P/E ratio is above the 5-year average (17.8) and above the 10-year average (15.9).
And yet, valuations arent too far out of whack. For the first quarter of 2021, the estimated earnings growth rate for the S&P 500 is 24.5%. Whats more, the U.S. economy is strongly bouncing back. Federal Reserve data indicate that U.S. gross domestic product growth could hit 10% in Q1 and thats even before passage of Bidens infrastructure plan.
The verdict: Bullishness is warranted but so is caution. Make sure your portfolio is properly diversified, with the right allocations. Put aside plenty of cash. Under current conditions, sensible allocations (as a general rule of thumb) would be 45% cash, 30% stocks, 15% hedges, and 10% bonds.
Value outperformed growth by 10 percentage points in Q1 and I expect the movement toward value to continue in Q2. I recommend that you rotate toward undervalued sectors (e.g., basic materials, consumer cyclicals, and communication services) and away from overbought ones (e.g., technology and health care).
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