The current sentiment on the street is bullish, except in institutional circles. Smart Money is not nearly as bullish as the masses. In fact, Smart Money is borderline bearish.
When I reference Smart Money, I am talking about an investor class that is very powerful, but whose models have recently broken. The collapse in earnings has rendered many forward-looking traditional investment models useless, except in one way. They can assess valuation risk using pre-crash earnings.
Before the crash the S&P 500 had a 25x multiple. At the time the economy was fine, unemployment levels were low, and although the market was expensive things were working. There was no impetus to sell, but valuations were excessive. Historically, the average PE on the S&P 500 is closer to 15x, so some considered the Market to be 40% above where it should be. This was true before the Corona Virus was even a recognized threat and it caused concern for Smart Money Investors.
However, this excessive valuation observation has worked only sporadically until now, and investors who used this as a thesis often found themselves switching sides again. The S&P 500 has been hovering around this 25x level for the past few years. The one-sided bullish market in 2017 pushed the multiple to these levels by the beginning of 2018, so it’s been here for a while.
In 2018, without stimulus and with an excessive multiple, there was a considerable amount of volatility. That was justification, suggesting that the Market was too expensive, and that mattered until the China Trade Deal was dangled like a carrot in front of the market during almost all of Calendar 2019.
The China Trade Deal was almost as influential as stimulus because it kept investors from selling. None of the Smart Money investors wanted to sell ahead of a Trade Deal, and that allowed the market to press higher modestly until November, when it broke loose.
In November the FOMC triggered a buy signal in our Evitar Corte Model, and the ECB began a new round of Stimulus. These catalysts worked to propel the market higher. Institutional piggybacking was obvious, and the multiple on the S&P 500 pressed beyond 25x too.
Those traditional models, which seem broken now, have this remaining. They know how excessively valued the Market was when everything was good, and now earnings have collapsed.
Moreover, the models, based on economic projections, can determine that earnings will not recover to their pre-corona crash levels quickly. The estimates suggest it will take a few years. If that’s true, then the fairer value for the Market is more like 15x than it is 25x.
That places fair value for the SPX at under 2000.
Some of these models would even consider that generous because the multiple based on earnings that had existed before should even be lower than 15x with the risks involved, but Central Banks have flooded the Market with liquidity.
Liquidity is important, it fostered a mentality of buying without consideration to risk or valuation in 2017 and in early 2020, but times are different now. We can still see piggybacking, where fast money is trying to get ahead of stimulus inflows, but risks are much higher in equities now.
Our recent report about the competing forces in this market suggested that fast money was at odds with smart money, but probabilities favor more adherence to risk in fast money circles now. Stimulus is certainly flowing but risks today are much different than risks in 2017 or in early 2020, so the piggybacking will likely experience ebbs and flows. Where it seemed one-sided and unabated in prior instances, we should expect piggybackers to back-off from time to time in this market.
When the piggyback influence tapers market conditions can change dramatically as the risk-assessments of Smart Money take hold. Reasonably, because the piggyback influence is fast money and fast money can turn from long to short fast, there could even be stages of much higher than expected volatility. This could happen even though the ECB and FOMC are pumping money into the financial system.
The Central Banks are doing everything they can to prop up financial markets, and they did a great job when the market was crashing recently, but it took a MASSIVE effort to get that done. The FOMC was injecting $100B per day for a while, where their max during the Credit Crisis was $80B per month!
That pace is unsustainable, and fast money is watching.
Since the market bottom, the big buyer at the other end of the table is buying less. The pace of asset purchases by the FOMC has slowed considerably, and it could come down enough to make the risk – reward of piggybacking skew negative sometimes.
Smart Money seems to be steadfast in their interpretation of risk, they seem to be aware of the bigger picture and the duration of the recovery, and they are not inclined to chase the market. Quite the opposite, they are more inclined to protect assets.
In summary, we should expect the fast money side of this duo to assess risk differently from time to time during this market environment, vs what we have seen in year’s past. When that happens we should expect drawdowns of relatively surprising magnitudes even though stimulus monies are flowing.
Ultimately, this could change the way we have come to define stimulus influences. If such an observation were to materialize, now could be one of those times.
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