One of the benefits of the quiet summer condition is that it gives portfolio managers an opportunity to analyze their holdings and ask serious questions about various investment strategies. Usually, as they go off to their vacation homes, they will quietly reflect on the condition of the market and positioning going into the rest of the year. During a recent conversation with a portfolio manager doing exactly that, my first question was, "What are you buying these days?"
The response I got was a bit frightening, "Yield…all I want is yield. Anything better than the 10-year note." After that conversation, I realized that today's market has bulls, bears and "yield hogs." But the one thing we old floor traders know for sure is that hogs get slaughtered!
Portfolio managers and investors alike have become yield hogs. In other words, they no longer care about the fundamentals of a given issue other than the yield versus treasuries. It doesn't seem to matter that equity valuations are being stretched and that corporate profits are not accelerating. The new wave of market participants, many in their late 20's and early thirties, seem to be buying equities with blinders on, or as an old friend Dennis DeCore would say, they have "the lemming mentality."
Investors have begun treating stocks as if they are bonds. One of the first lessons every new trader learns is that when stocks are treated like bonds, it can't end well. Stocks are not bonds. They have corporate and capital risk not to mention governance and regulatory concerns. Bonds, although expensive, have the full faith and credit of the U.S. treasury backing them. That is a huge difference especially when capital preservation becomes necessary.
Let's be clear; the equity and bond markets are largely being fueled by central banks both directly through their low, and even negative, interest rate policies and indirectly by market prospects that those policies will be maintained until further notice.
As we watch the market keep churning daily with new record highs on light volume, the fundamentals are becoming more and more uncertain. The earnings season, hitting very low expectations, added to the problem. With the equity market moving higher, we are now expanding the multiple on the S&P 500 to the higher end of historic valuations. With a median price to earnings ratio for the S&P 500 being roughly 16, we now face a market with a P/E approaching 20.
This is happening in a year with dysfunctional electoral politics and other serious headwinds such as growth, or pro-growth policies, becoming a distant dream. A simple contraction of the multiple could send the S&P 500 down 200 to 300 points. This rally, although very impressive, is starting to show signs of 'running out of gas'.
After Brexit, and because of the uncertainties which lay ahead the next few months, I advocated raising cash and the market complied. Then, we witnessed a nice rally allowing sellers the luxury of having the market come to them. It seems big, smart money did the same as cash on the sidelines went to record levels of $1.7 trillion as of the end of July.
But if raising cash is not an option, then use the benefit of very low volatility to add protection in the portfolio. Remember, when the market does turn, it will be fast and vicious and leave very few prisoners; It will not give the average investor a chance to hedge out exposure. The time will come when the fundamentals of the marketplace aren't as cloudy and the market will go through earnings and multiple expansion on a sound, fundamental basis. Until then, 2016 remains "The Year of Living Dangerously" for the markets.
