Is This Market Recovery For Real? Separating ‘Genuine’ From ‘False’ Bottoms

US tech stocks are the most crowded trade on the planet. And it’s not even close.

In fact, 74% of respondents identified “Long US Tech & Growth” as the corner of the market exhibiting the most crowding in the latest edition of BofA’s Global Fund Manager survey.

As the bank’s Michael Hartnett notes, that is “the highest reading in FMS history”.

By now, investors should be well apprised of the narrative. The surge in US tech (which pushed the likes of Apple and Amazon to record highs recently, alongside the Nasdaq) is indicative of a rally which, despite outward appearances, isn’t as disconnected from economic reality as some casual observers charge.

Investors’ penchant for secular growth and other equities expressions tethered to the duration trade in rates betrays a cautious stance.

Think of it as a real-time, running referendum on the re-opening push in the US.

In that regard, relative performance of mega-cap tech, cap-weighted versus equal-weighted, and, importantly, factor behavior, together serve as a market-based barometer of expectations for the vitality of the nascent recovery.

Read more:

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In addition, a preference for tech clearly suggests investors believe the post-pandemic world will be defined by reduced in-person interaction and increased digitization of the human experience.

Crucially, this is really no different from the post-financial crisis environment. It is, as I put it late last week, “zeitgeist unchanged“.

With the exception of a few weeks at the end of May/early June, the recovery in US stocks since March has a decidedly defensive feel to it. This is underscored by gold’s ascent, and relentless inflows into gold ETFs.

Once concern is that the character of the rally suggests investors will be quick to flee the scene in the event renewed lockdowns prompt another deceleration in economic activity. Either that, or the rally will become narrower still, as the only viable strategy for staying invested while simultaneously protecting oneself is to get even more overweight secular growth.

SocGen’s Solomon Tadesse recently took a look at all of the points raised above in an effort to answer the only question that matters: “Is this market recovery for real?”

“Economic theory and conventional wisdom suggest that in the aftermath of cyclical downturns, when economic recovery is on the horizon, the abundance of prospective macro growth provides fertile ground for a clear and strong rebound in out-of-favor distressed assets, such as cyclicals”, he writes, adding that in real recoveries, “one would expect a dramatic rotation from defensive strategies that carried the day leading up to the bottom”.

As a side effect, “markets often experience sudden crashes in Price Momentum since such strategies, after riding the defensive rally… lose sight of the change in trend when defensives suddenly pass the leadership baton”, he notes.

That is precisely what JPMorgan’s Marko Kolanovic expects to see going forward, and Morgan Stanley is generally on the same page. In a note out earlier this month, Kolanovic said the rally can continue, but flagged scope for “a repricing” of recent trends which have driven mega-cap tech and secular growth to record highs at the expense of cyclicals, high beta, and value. That repricing, if it occurs, “could result in a rapid momentum selloff and value rally”, he cautioned.

Tadesse notes that “history provides an almost ideal experiment in the form of two bear market bottoms, one false the other genuine, that came to pass within a matter of two years under almost identical economic conditions”.

Those two market bottoms followed the 1929 crash. One led to “a spectacular rally of almost 50% within four months but eventually turned out to be false”, while the other “saw a historic market surge that lasted for years without brushing a fresh bottom”, Tadesse adds.

As it turns out, one could have divined something meaningful about the likely durability of the rallies by observing the behavior of cyclicals.

“Cyclical stocks gave a vote of confidence at the 1932 market bottom and staged a remarkable rally (right figure) whereas, despite the staggering broad market rally of 47% after the market bottom of 1929, cyclicals could see through the veil [to] the fragility of the underlying economic recovery”, Tadesse goes on to recount.

Generally speaking, similar disparities can be observed across factors and styles, suggesting there was an abundance of clues as to which bounce was “false” and which was “genuine”.

On the flip-side, Tadesse writes that “Price Momentum experiences a downward correction of about 10% during bear market bottoms and about 20% in severe market bottoms [but during] the 1929 market bottom [it] continued to rally”. That probably should have been a warning sign.

So, where does that leave us in 2020? Well, as Tadesse notes, the cyclical recovery “so far during this crisis has been volatile and weak”, albeit with pockets of outperformance. Over the past several sessions, for example, small-caps and value have outperformed mega-cap tech and growth.

“Time will tell if the most recent cyclical strength persists, signaling a stronger economic recovery”, he says.

Coming full circle, respondents to BofA’s survey unsurprisingly identified a new wave of the virus as the biggest tail risk. Asked what the most likely catalyst would be when it comes to an unwind of the crowded long in US tech and growth, they identified a COVID vaccine.

If and when a vaccine becomes a reality, one should expect a rapid rotation under the hood in equities. Until then, I suppose we should all just hope (and pray) that tech earnings don’t disappoint.

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