Expected consolidation has begun, time of extreme positions, positioning of the world's largest investors

Chart of the Week

The chart shows the interest rates investors have received on a 10-year government bond since 1789, minus inflation. This is called the real yield.

Why this matters‍

Everyone is talking about interest rates rising again. So, these should be good times for bond investors, as they are now receiving higher interest payments. Or are they?

What matters is not nominal interest rates, but interest rates after inflation — the real interest rates. While bond investors are currently receiving higher interest payments, inflation is at a historic high and is eroding those returns. Investing in bonds is still not worthwhile at the moment.

The best investment during times of high inflation is stocks. In periods of steadily rising inflation, stocks are considered the best inflation hedge. Companies own many real assets that increase in value with inflation and can also raise prices to maintain their profit margins.

Expected consolidation has begun‍

90% of companies have now reported earnings for the second quarter of 2022. Until last week, 75% of companies had beaten expectations — a very strong result. However, this week only 50% of companies exceeded expectations. That was enough to break the steep upward trend of recent weeks.

China’s economy is not doing well. The repeated lockdowns of entire regions due to the Zero-COVID policy and the still-smoldering real estate crisis are weighing on the country more heavily than expected. This week, energy rationing caused by drought was added to the mix. As a result, China’s central bank unexpectedly cut interest rates.

The weak economy may be one reason behind China’s harsh reaction toward Taiwan, but from our perspective, it is also the reason why the situation is unlikely to escalate further. Xi Jinping aims to be nominated for a third term as president by the National People’s Congress this autumn. He is facing internal pressure over his economic policies. A conflict with the US and Taiwan helps unite the ranks internally.

At the same time, however, he cannot risk a war with Taiwan and the US, as China would then face sanctions similar to those imposed on Russia. China’s economy is currently too weak to withstand this, and the risk of the economic situation spiraling out of control before his re-election is too great.

The stock market was also shocked by the very high inflation figures in England, which exceeded 10%.

All of these developments have led the stock market to enter a consolidation phase.

The chart shows how many stocks are currently trading above their 50-day moving average. It is worth paying attention to such “technical indicators” to better assess the market. As recently as June, it was an excellent time to enter the market, and since then, the market has risen as strongly and quickly as it has in a long time. A consolidation therefore seemed inevitable.

However, such aspects are more relevant for short-term investors. Medium- and long-term investors, which we consider ourselves to be, remain invested even during such phases. The stock market always fluctuates back and forth — what matters is recognizing the broader trends. And these include the relationships we outlined above under the Chart of the Week.

The chart shows the US Purchasing Managers’ Index (red, ISM PMI) and new orders minus inventories. Inventories are currently rising sharply. After the COVID period with many supply bottlenecks, it is understandable that many companies are now restocking more aggressively. However, this is usually a signal of declining production levels ahead. A certain degree of caution when investing is therefore certainly warranted.

The chart shows the development of short-term 2-year interest rates compared to the S&P 500. As explained in many previous blogs, interest rate developments are crucial for the future direction of the stock markets. In recent weeks, stock market prices have been able to decouple from bond yields. However, this was also the case in March and April of this year.

We believe these two lines will converge again. This can happen either through falling interest rates or declining stock prices.

Time of Extreme Positions

Every three months, major investors in the US are required to disclose their holdings to the SEC. This allows the activities of some of the largest and historically most successful investors to be observed. At the moment, the figures could hardly be more different, which also reflects how difficult it currently is to develop a sound investment strategy.

Michael Burry, who is likely familiar to many from the movie The Big Short, has sold nearly all of his holdings, including positions in Amazon and Apple. Earlier this year, he had still invested $55 million.

Michael Burry famously predicted the 2007 housing crash and earned hundreds of millions from it. He currently believes that the reduction of the balance sheet by the US central bank, combined with interest rate hikes, will lead to a total collapse of the economy and the stock markets. He compares the market to a drug addict being cut off from drugs (cheap money).

On the other side, we have Warren Buffett — one of the world’s most well-known investors. He began his investment career in 1954 with USD 105,100. Today, his fortune amounts to more than USD 110 billion.

Warren Buffett is a long-term investor specializing in value stocks. More than almost any other investor, he embodies the investment philosophy of Benjamin Graham, the founder of (deep) value analysis. Stocks are purchased at a discount of more than 30% to their intrinsic value and held for the long term.

In recent weeks, Warren Buffett has bought aggressively and significantly increased many of his positions, including in Amazon.

‍Positioning of the World’s Largest Investors

Interesting each month is the survey conducted by the Bank of America among major institutional investors on how they view the markets and how they are currently positioned. Institutional investors account for around 85% of total trading volume. Their decisions move the markets.

Here, institutional investors were asked how heavily they are currently invested in stocks. For most investors, equity exposure is below average. They are either holding cash or have hedged their positions using futures. Institutional investors generally have to remain close to 100% invested and can only park money in cash for short periods. This is encouraging, as there is still a significant amount of capital that could flow into the market and drive it higher.

Here, investors were asked where they currently see the greatest risks. Fear of a global recession has remained at the same level as last month, but more and more investors are concerned that inflation will stay elevated for longer. As explained above in the Chart of the Week, stock investments are precisely the right way to protect against inflation.

Here, investors were asked what would need to happen for the US central bank to stop raising interest rates. Most believe this will only happen once inflation falls below 4%. Even under the most optimistic forecasts, this is not expected to occur until next year.

A level of 3,500 for the S&P 500 is also being mentioned. That would represent a further decline of 20%. At present, it should therefore not be assumed that the central bank is focused on stock prices. A “Fed put,” as we often saw in recent years, does not currently exist.

Here, investors were asked whether they believe growth stocks or value stocks will perform better in the coming months. A reading above the zero line indicates an expectation that value stocks will outperform. The camps are almost evenly split, but for the first time since May 2020, slightly more investors expect growth stocks to outperform in the months ahead.

Here, investors were asked which asset class they currently see as carrying the greatest risks — or where positioning is already overcrowded and the trend is unlikely to continue much further. Clearly in first place is the strong US dollar. Major institutional investors are therefore unlikely to increase their USD positions much further and may instead begin reducing them. However, much depends on the course of the war in Ukraine. During periods of global uncertainty, investors tend to “flee” into the US dollar.

Additional image sources: Introductory graphic Designed by Freepik.

‍

Disclaimer:

The content in these blogs is intended solely for general informational purposes and to help potential clients gain an understanding of our way of working. They do not constitute recommendations to buy or sell assets and are not investment advice. Marmot Finance cannot assess whether or how the statements made align with your investment objectives and risk profile. Anyone making investment decisions based on these blog entries does so entirely at their own responsibility and risk. Marmot Finance cannot be held liable for any losses incurred based on information contained in these blog posts. The products mentioned are not recommendations, but are intended to demonstrate how Marmot Finance works and selects such products. Furthermore, Marmot Finance is completely independent and does not earn money in any form from product providers.