‘Rationally Being Irrational’ (And The Second Half Playbook)

A second consecutive weekly gain for the S&P brought US equities back near their June post-pandemic highs.

Big-cap tech, meanwhile, rose nearly 5% for the second straight week, widening the gap with more egalitarian gauges and raising familiar concerns about market breadth.

Apple and Amazon are perched at records. The equal-weighted S&P is down more than 6% over the past month.

All of this is set against a backdrop of economic precarity and political upheaval. This tenuous state of affairs is reflected “under the hood” (i.e., in underperformance by cyclicals and value, and outperformance by secular growth), but still leaves one to ponder the possibility that equities, as an asset class, are detached from reality.

Earnings uncertainty is rampant. Rising bankruptcies and a surge in permanent job losses (figure below) suggest structural damage to the US economy. And reinstated lockdown protocols across “hotspot” states point to downward revisions in growth outlooks and a possible second round of layoffs.

So, are risk assets being “irrational”?

Yes. And also no.

“Markets are rationally being ‘irrational'”, BofA’s Michael Hartnett writes, previewing the second half of what has already been an extraordinary year both for investors and humanity in general.

“Government and corporate bonds have been fixed (‘nationalized’) by central banks, so why would anyone expect markets to connect with macro?”, he goes on to ask. “Why should credit and stocks price rationally?”

This is the “administered markets” point again, and it recalls a short note by Deutsche Bank’s George Saravelos which I cited in early April. “At the extreme, central banks could become permanent command economy agents administering equity and credit prices, aggressively subduing financial shocks”, he mused.

Read more: Imagine A Future Where Asset Prices Are Administered

So, what’s the strategy in the second half considering the unfathomable range of possibilities both economic and sociopolitical?

Well, for Hartnett, the view right now remains broadly similar to what it’s been for weeks. Namely, “still bullish risk assets” with the S&P seen hitting 3,250, at which point it would be time to sell the rip. Any dip below 2,950 is one worth buying.

From a strategic asset allocation perspective, Hartnett favors the following: “25% in ‘growth’ (CCMP, ChiNEXT, DAX, KOSPI), 25% in ‘yield’, (IG, HY, EM local currency bonds, utility stocks), 25% in ‘quality’ (T-bills), 25% in ‘inflation’ (gold, EM banks, small cap value)”.

So far in 2020, gold and bonds are the standouts, although the figure (below) obviously looks quite a bit different if you break things down by quarter.

The winners in terms of flows this year are clear — gold and cash.

You’re reminded that while cash levels are slowing receding (here and here) indicating a tentative penchant for re-risking among investor cohorts who fled to money market funds during the panic, there’s still a near-record amount of “dry powder” on the sidelines.

Finally, when it comes to events with the potential to stoke volatility and otherwise “break the range”, BofA’s Hartnett sees a “packed” schedule.

The Fed’s decision on yield-curve control is coming (probably in September) and on that front, he notes that if they do it, it means “peak stimulus”, but if they don’t it still means ”peak stimulus”. (Got that?)

US-China tensions could “ratchet higher”, while the US election will “get priced-in just as society gears up for a clash between virus-lockdown and back-to-office/back-to-school momentum”, Hartnett writes.

Plan accordingly.

Oh, and BofA’s “Bull & Bear Indicator” is still in “buy” territory, but well off the most extreme levels and nowhere near ebullient.