‘Extremely Stretched’ (But Bullish Nonetheless)

I recently spoke of “undeterred” investors. Despite the tumult catalyzed by volatility in rates, market participants continued to pour money into equity funds over the past several weeks.

While the breakdown suggested a tilt towards cyclical value (a “go-with-it” lean as investors favor equities expressions poised to benefit in the type of economic environment that bond yields appear to be anticipating), you can probably thank simple dip-buying too.

I’ve been over this before in these pages. Years of classical conditioning saw “BTD” morph from a derisive meme about retail investors into a virtually infallible “strategy.” I’ll recapitulate a bit.

How was “BTD” legitimized? How did it come to be that “BTD” went from standing joke to a real thing? Part of the story was the vaunted “Goldilocks” macro narrative, but when it came to central banks, the two-way communication loop between policymakers and markets became a self-fulfilling prophecy. Markets became so conditioned to policymaker intervention and dovish forward guidance that no one saw any utility in waiting around for it anymore. After all, if you know it’s coming, why wait on it? Why not buy the dip now? Eventually, investors were buying the prospective dip.

In his latest note, Goldman’s David Kostin drove home the “undeterred” characterization. “Equity mutual fund and ETF inflows have totaled $163 billion since the start of February, the largest five-week inflow on record in absolute dollar terms and third largest in a decade relative to assets,” he said on Friday evening.

“Even though the recent backup in rates has weighed on equity prices broadly, the pace of inflows into equity funds during the last few weeks has accelerated compared with the start of the year,” Kostin added. The emphasis is in the original note.

You might recall that in the 16 weeks through the end of last month (so, since the election), investors poured $414 billion into shares. Bloomberg data revealed a historic month for stock ETFs in February, when equity products took in some $86 billion (figure below).

Goldman went on to observe the same preferences vis-à-vis the reflation narrative. The rotation into equities has favored EM, value, small-caps, and materials. Obviously, that’s indicative of a tilt towards sectors and styles expected to perform in a pro-growth environment.

The right figure (in the two-pane from Goldman above) shows that equity funds typically experienced inflows as real rates and breakevens rose over the past decade. “This is intuitive given that the dynamic typically occurs when growth expectations are improving,” Kostin said.

However, rapidly rising real yields are obviously a headwind for risk assets, especially when valuations are stretched. As Goldman has repeatedly emphasized, it’s the rapidity of rate rise that matters, and the recent backup was pretty rapid. Several banks (including Goldman) revised higher their year-end forecasts for bond yields last week.

In part due to the deluge of inflows described above, Goldman’s sentiment indicator is now at two standard deviations or, more colloquially, “extremely stretched.”

But as you can surmise from the simple figure on the right (below), it’s not all about fund inflows. Kostin flagged near decade highs in hedge fund net exposure, CFTC net futures positioning, and foreign investor equity demand.

“Stretched investor positioning has exacerbated the sharp recent equity market response [to rising yields], particularly because both hedge funds and retail investors have held large positions in long-duration equities that are particularly sensitive to interest rates,” he remarked.

As I’ve repeatedly warned, most retail investors are not cognizant of the extent to which their portfolios are likely stuffed with duration-sensitive assets — that’s just not how “regular” people are trained to think, mostly because they’re not “trained” in the first place. Well, other than to salivate when Pavlov’s bell rings which, ironically, has generally meant stuffing their portfolios with more secular growth over the years.

Anyway, the good news is, Goldman reckons hotter growth in the US will likely “offset the headwinds” from stretched positioning. Indeed, history shows that when the bank’s sentiment indicator was stretched during periods of accelerating growth, US equities tended to rise smartly over the next two months. One way to conceptualize that is just to dryly note that stretched markets have a tendency to get more stretched due to, for example, the “FOMO” dynamic, before the rubber band finally snaps back.

Ultimately, Kostin reminded market participants that money market funds are still swollen, and with cash likely to yield nothing (or next to nothing) for the foreseeable future, the allure of stocks will be strong. In fact, Goldman estimates that household demand for equities will outstrip corporate demand in 2021, even as the latter bounces back after the pandemic dealt a blow to buybacks.