Looking At: Tone Shift in Markets

Estimated reading time: 5 minutes

Challenging the Bulls

With market risks climbing again, the uncertainty is palpable and people are feeling jumpy. Bullish investors are having to defend their opinions more passionately — and for good reason. It’s getting more difficult to find clear positive signals. 

We’ve remained bullish and constructive on this market despite the constant barrage of challenges being thrown at it — war, rising oil prices, breakdowns in momentum, private credit headlines, high valuations, you name it. We are still constructive, but we do believe we’re in the midst of a tone shift that is creating cracks in investor sentiment.

As of Wednesday morning, the S&P is up roughly 10% this year. For mid-July, that’s pretty darn good when compared to long-term average returns. When compared to the past three years, however, it’s rather unimpressive. 

Part of the recent shift reflects the increased dispersion among stocks. The best performers and the worst performers on any given day are seeing some of the widest spreads in decades. We can visualize this by looking at return dispersion for technology stocks vs. non-technology stocks. In recent months it’s remained relatively flat for non-technology stocks, but is almost off the charts for tech.

Frustratingly, that isn’t a definitively good or bad sign, but it does make investing in single stocks increasingly dramatic. 

This may not be obvious to investors who use broad-market ETFs since volatility for the S&P 500 broadly has been low, and buying protection in the form of put options is relatively cheap.

This masks the churn that’s happening under the surface, and the opportunities (or risks) that lurk for investors trying to find the next big winner. 

Risk Seekers Beware

The tone shift also reflects what we’d call whale hunting — investors broadly searching for the next stock or industry group that’s going to produce blowout returns. 

For the average investor, we think that’s a bad approach in this market. We know it’s more popular and even fun to trade individual stocks, but unless you’re doing deep fundamental research on the companies, this type of market environment is more likely to punish you than reward you. 

Choosing individual stocks during periods of strong upward momentum and lower dispersion allows more companies to ride the wave. Right now, however, momentum factor volatility is the highest it’s been in years – even decades, depending on the exact basket of stocks compared – which can be an unforgiving environment for those trying to trade around it. 

What’s the message here? Stop searching for the next blowout stock. If you’re bullish on AI and the market in general, use broad ETFs and protect yourself with cheap put options on the index. Don’t get too cute.

Last But Not Least

The geopolitical environment has also shifted. The war in the Middle East has re-escalated and the number of ships moving through the Strait of Hormuz has once again fallen to near-zero, causing oil prices to move higher along with Fed rate hike expectations. 

Any optimism of deescalation that markets were enjoying in June has quickly dissipated in July. For now, inflation expectations remain tame, (important for the Fed’s decision making process,) but the heightened risks and increasing possibility of tighter monetary policy serve as a notable headwind for sentiment in the near-term. 

Personally, we thought this conflict was coming to an end, and we’ve had to revisit our investment theses in light of current events. Rate hikes and lasting inflation pressures would be bad for markets and the economy, yet it seems that many investors are still looking through these risks. That’s probably OK for now, but not forever. 

Stay vigilant, stay flexible in your opinions, and respect what the data is saying.

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