Lee Adaptive Strategies Update
April was another strong month for the equity markets, with the S&P 500 up 5.26% on a total return basis. It is now up 11.84% year-to-date and an astonishing 64.70% since March 31, 2020.
April’s gains felt quiet and somehow relentless. There were only four trading days during the month in which the index moved by more than one percent, as against eight such days in March and eighteen during the first quarter of the year. Of course, all four of those days were gains of greater than one percent rather than losses. In contrast, three of the eight in March were losing days, as were seven of the eighteen in the first quarter.
Subjectively characterizing investors’ current mood is a challenge. The cliché that they are “cautiously optimistic” seems somewhat apt, but misses the mark. The market is certainly optimistic, but can we call it cautious? Confidence may not be at the same historic highs as the index, but caution seems to have been left far behind. Bewildered is perhaps a better term. The market is up almost two-thirds over thirteen months. That sounds impossible, and yet, somehow, it just happened.
The world is finally emerging from a unique and frankly awful year. Of course, the pandemic continues still, but the worst is well behind us and, at least in the US, the economic fetters are almost all gone. Investors are like people who went to bed during a terrible storm and were awoken after a fitful sleep by bright sunshine. Bleary, it takes a few moments to regain bearings and a little while longer to focus the eyes on objects in the room.
When the objects became clear, investors discovered an economy on the edge of an old-style boom and an equity market that has been hitting new highs for months. Signs of a boom are everywhere, from official economic indicators to an endless supply of anecdotes. Las Vegas is crowded again. The residential real estate market is in a frenzy. Restaurants that were recently trying to keep afloat at less than half occupancy now turn away customers without reservations. In our neighborhood the post office has taped help wanted signs to mailboxes. We recently received an email offering work at Chipotle. (We did not reply, although the offer of free burritos was tempting.)
And what is fueling this economic renaissance? The reassuring and reasonable sounding explanation is pent up demand. Folks who spent a year hiding in their houses can now go to the mall and catch up on their consuming. That is part of the story, but it works a lot better as an explanation of heightened apparel sales than why Vegas is busy or why we have trouble getting a table at the local eatery.
A much more succinct explanation is that many Americans are flush with cash and, unlike six months ago, they have enough confidence in the future to spend it. Sources of this cash include money saved during more fearful days, but the primary driver is a raft of government programs and historically low interest rates. And that boils down to a massive and unprecedented increase in the money supply.
In the most abstract of principles, an increase in the money supply ought to raise prices, but not affect the real economy. One can imagine a 5-for-4 split in the US dollar. The government announces that starting on a certain date in the future, all old dollars will be exchanged for 1.2 new dollars. Of course, everybody would adjust all prices upwards by 20% on the day of the split and nothing much would happen. The same goods and services would be purchased by the same people, just using new dollars and new prices.
Of course, nothing like this happens in real life. To a business at ground level, it is very hard to distinguish between an increase in the money supply and a welcome increase in demand for your products, particularly if inflation has not been experienced in the recent past. So instead of raising prices you expand production, hiring more workers, buying more inputs, etc. Thus, a boom and a real effect on the real economy.
Ultimately, inflation will be broadly recognized and businesses will regret producing more rather than raising prices. But this takes time. At first, price increases will be written off as “reflation” an undoing of recession driven deflation. Then a few areas of the economy will experience price increases due to what will be called shortages, even though supply is not particularly reduced. (Houses, microchips for cars, and restaurant help are current examples.) Soon enough, price increases trickle out to the entire economy.
What does this mean for equities? As we have written in previous months, the impact of inflation on stock prices is somewhat ambiguous. Stocks are not dollar denominated, they represent the ownership of real assets, so they ought to at least rise with prices. On the other hand, if equities rise in response to an economic boom that turns out to be more inflationary than real, then rising prices could be bad news. For now, we are comfortable being fully invested in equity. Call us cautiously optimistic.
The Market Sentiment Framework
We use our Market Sentiment Framework to adapt the mechanics and weightings of our full quantitative models to changing market conditions.
The Sentiment Framework gauges the current state of market psychology on two dimensions. Efficiency measures the crowdedness of the market, the volume of participants seeking investment opportunities. Lower levels of efficiency imply more market mispricing. Optimism measures the willingness of investors to take on risk in exchange for distant and uncertain rewards. Higher levels of optimism imply a better outlook for risky asset classes.
Optimism fell during April, while Efficiency was largely unchanged.
Optimism began the month at 0.67 and continued its rising trend for the first half of April until reversing to end the month at 0.35. Combined with a low absolute level, this change in direction suggests some weakening in market outlook.
Efficiency also fell slightly, starting the month at 0.71 and ending at 0.69. Efficiency continues to be comparatively low in absolute terms, which suggests a market that is still under stress.
Both measures are higher than where they were pre-COVID. The current positioning of the Sentiment Framework implies a market that is functioning less than ideally, with marginally optimistic but fearful investors. This would imply a positive but challenged outlook for the market as a whole, but possibly an opening for value strategies to find opportunities.
By: Nathan Eigerman