“Global growth optimism surged by the most in 20 years to 18-month highs.”
— Michael Hartnett, chief investment strategist at Bank of America, November 2019
Merrill Lynch, the investment bank division of Bank of America, recently published its monthly survey of investment managers. For now, the bulls seem to be back.
The BofA-Merrill Lynch November survey found that cash on hand is now at its lowest level since June 2013, posting its largest decline since the 2016 election.
Just a few months ago, investors were worried about an impending recession — pointing to trade wars, inverted yield curves and slowing growth. Now, folks seem to be rushing back into the market they previously spurned.
Recently data shows the current optimism may be justified, but there are long-term considerations to weigh.
Let’s look at some of the data.
If you compare the earnings-yield of the S&P 500 index of companies to the interest-rate-coupon paid by the 10-year Treasury bond, you earn a lot more today in stocks. Historically that spread has been pretty narrow, but the low interest rates of today favors stocks.
That wide spread could resolve itself in a couple of different ways. Today’s tech-heavy stock indexes that benefit from low interest rates could continue to run higher which would compress the S&P 500 earnings yield.
Or, rates could rise.
If rates rise, the tech-heavy, growth-centric indexes, would likely sell off, but more traditional “value” investments would likely perform well.
Interestingly, while we have been pounding the “value investing” drum for some time, Merrill Lynch data shows U.S. value stocks are as attractive as they have ever been in history with respect to “momentum” stocks. For those interested in the details, the divergence is now greater than 2 standard deviations from their norm.
One of the most powerful forces in finance is “reversion to the mean.” If something is 2-standard deviations below the mean today, that creates a long runway for value stocks to shoot higher from here, just to get back to “normal” levels.
Another anomaly in today’s low interest rate world is the relationship between stocks and commodities. That relationship has been skewed toward stocks and away from commodities for several years now. But, again, the skewing is as wide as it has ever been.
If we believe in “mean reversion” — stretched rubber bands snapping back to their normal levels — then commodity-related stocks should outperform other stocks over the next 10 years.
With deficits now breaching $1 trillion per year, or roughly 4% of GDP, these trends become more stark.
Typically, these levels of deficit spending are reserved for wartime or recessionary periods. If one or both of those occur, deficits could easily shoot to 10% of GDP or more.
This would either drive rates higher or weigh on the dollar, or both. Typically, those dynamics are not good for momentum stocks, but are tailwinds for value and commodity stocks.
As volatility has come down, and investors are expected more gains to close the year, we are a bit more cautious.
While we are heavily invested in the value and commodity anomalies discussed above, we are also taking advantage of the lower volatility to hedge more of the portfolio and build some cash.
While the impeachment parade continues, and the trade war debate marches on, the administration is higher incentivized to keep the markets and economy healthy leading up to the election.
That is likely to provide tailwinds for investors in the near term, but don’t be afraid to build some buffers in advance of the election next fall.