Shattering Market Records on the Basis of ‘Smooth Sailing’ Next Year

• Russell 2000 has its best month in history
• Dow Jones trades above 30,000 for its best month since 1987
• Are most traders now leaning to the same side of the boat? 

Santa is coming… 

He might be a little late but the gift of more cheap money is almost certainly on the way. 

Great news!

Low credit spreads, trillions in fiscal stimulus with short-term rates anchored below zero through 2023 is “Christmas” for risk assets. 

All that was missing was some visibility past the pandemic.. 

But thanks to multiple effective vaccines… markets seem to think we are as good as there. 

Phew. 

Just as well we have a magic silver bullet… things were looking shaky there for a while. 

Records are being broken left right and centre… 

Let’s start with a quick look at the returns for all major US indices over 2020… as the Dow Jones pushes past the psychological 30,000 level… on track for its best month since 1987

All Indices – 2020 Returns

The Nasdaq reigns supreme – with returns now above 31% for the year. 

However, the late charge over the past four weeks has been in “old economy” stocks (via the Dow Jones); and most notably small caps (Russell 2000). 

At the start of November – the Russell 2000 was down around 14% – but fast forward a few weeks and it’s positive 6%. 

Russell 2000 – Its Best Month Ever!

The small-cap index rallied 1.9% today and hit a fresh all-time high (see below).

That gain put the Russell on pace for its best month ever, up more than 20% in November.

Russell 2000 on-track for its best ever month

However, be warned, the FOMO rally is now looking stretched… as our weekly RSI shows (in the lower window)

Small cap stocks are often seen as riskier investments than their large cap peers, and they tend to trade like cyclical shares.

In an economic downturn, concerns about sharp profit declines and bankruptcies can hit smaller stocks particularly hard because those companies may have less developed revenue streams and less access to the credit markets than more established companies. 

Obviously that trade flips if the economic (and credit) situation improves (i.e., as tech stocks with fortified balance sheets stop becoming the market’s “safety blanket”)

Whilst I understand the trade opposite the promise of a widely vaccinated population – the trade is overdone. 

My bet – look for this Index to give back at least 5% over the next few weeks.

As an example, just look at what we’ve seen on the other three occasions we’ve seen the RSI push past a level of 70. 

Investors are now Nostradamus 

From mine, the market is now making a big assumption that there will be seamless (or frictionless) integration between fiscal and monetary policy. 

And there might be… 

But it’s a bold assumption. 

And whilst I think the next six weeks or so will most likely be positive for the market – what follows in early January will be critical to the success of 2021. 

But perhaps what worries me most is the ‘echo chamber’ of opinion across the industry. 

For example, whether it’s Goldman Sachs, UBS, Bank of America or JP Morgan (or some other ‘expert’ stock market analyst) — all of them are echoing a similar investment strategy for next year.

It’s a combination of the following themes:  

• diversifying out of the U.S.
• avoiding over-valued FAANGs
• moving more into global stocks (particularly cyclicals and emerging markets); and
• expect a much weaker US dollar due to soaring fiscal deficits

By way of example, here’s UBS recommending cyclicals over defensive sectors and technology

“The Re-Opening Trade for 2021” 

Again, on the surface – it feels right.

But as I (sarcastically) reminded readers only yesterday…. what could possibly go wrong?

Don’t get me wrong – I am not a bear. 

The market is in a solid place for the near term… where I remain cautiously bullish. For example, I put on three new bullish trades late last month and each of them are doing okay (for now).

When I think of what matters to stocks (less so the economy) – we are swimming in liquidity; credit swap spreads remain very low; and the Fed are committed to keeping rates low. 

But I also know that when everyone runs to the same side of the boat… more often than not the boat tends to tip. 

So what could go wrong? 

Some things which come to mind include (and this list isn’t meant to be exhaustive):

• Friction with Congress between a (likely) Republican controlled Senate and Democrat House towards a second round of meaningful stimulus (i.e. $2 Trillion plus);
• Extended lock-downs from State authorities due to massive COVID outbreaks before a vaccine is available at scale;
• People don’t trust the vaccines in the absence of data and choose not to get vaccinated;
• Problems with widespread vaccine distribution logistics;
• Inflation gaining far more traction than what’s priced in – leading the 10-year yield to rise above 150 basis points; or the
• Fed shifting its language on short-term rates and/or additional QE

Today, it feels like the entire focus from investors is on recovery from COVID-19 and widespread vaccination. Once we clear that – we are “over the line”.

Put another way – all other risks are immaterial.

Let’s hope so.

But from mine, typically that kind of thinking isn’t helpful.

Before I close (and setting up tomorrow’s post) – I’m now starting to take a closer look at the recent price action in gold.

The yellow metal has been clobbered lately on the promise of a much stronger economic outlook (e.g., as bond yields improve).

But the selling in gold could be over-done… more on that tomorrow.

Regards,
Adrian Tout