June 12, 2023 – Mr. Market, as legendary value investor Ben Graham once called it, can be a fickle guy. One day, he could panic, wanting to sell his businesses far below their intrinsic value, as occurred briefly in the spring of 2020. Then, just a few years later, Mr. Market could be bidding certain businesses, particularly those with a tinge of AI attached to them, to prices that far exceed any reasonable measure of intrinsic value.
In Ben Graham’s analogy, he portrayed Mr. Market as a business partner who offers to buy or sell stocks to investors every day. Mr. Market is an emotional and unpredictable character, sometimes optimistic and exuberant, and at other times fearful and despondent. His moods can swing dramatically from day to day or even within the same day. Mr. Market is rarely level-headed and rational.
Graham’s disciple, Warren Buffett, often spoke of dealing with irrational markets. In his 1986 annual letter to Berkshire Hathaway shareholders, he spoke of “occasional outbreaks of those two super-contagious diseases, fear and greed, will forever occur in the investment community. The timing of these epidemics will be unpredictable. And the market aberrations produced by them will be equally unpredictable, both as to duration and degree. Therefore, we never try to anticipate the arrival or departure of either disease. Our goal is more modest: we simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.
As this is written, little fear is visible in Wall Street. Instead, euphoria prevails – and why not? What could be more exhilarating than to participate in a bull market in which the rewards to owners of businesses become gloriously uncoupled from the plodding performances of the businesses themselves. Unfortunately, however, stocks can’t outperform businesses indefinitely.”
Buffett could have readily penned that letter in 2023, as greed rules the roost in the current market environment, particularly in large-cap growth stocks that now dominate the S&P 500.
Source: CNN
Currently, stock market investor sentiment is at the “extreme greed” level. Numerous technical indicators, including the volatility index, junk bond yield spreads, and the put-call ratio, are at their lows, signaling euphoric conditions. U.S. large-cap equity valuations have bounced back significantly in 2023, leading to an equity risk premium, or the additional return that stock investors should be compensated for taking on equity risk above bonds, now approaching zero.
Source: Bloomberg
What caught many level-headed investors off guard this year is the rally in speculative stocks, despite last year’s bear market and the continued rise in interest rates. Rising interest rates correspond to an increase in the rate at which investors must discount future cash flows to calculate stocks’ intrinsic values. Increased discount rates lead to lower present values of future cash flows on average and correspondingly, lower intrinsic values for stocks. Soaring stock prices combined with declining intrinsic values is a dangerous combination for go-forward returns and increases the probability and magnitude of a painful correction in stock prices in the future.
However, it appears that market participants are being greedy in only certain parts of the market, specifically, the largest and most liquid securities trading on U.S. equity exchanges.
Year-to-date, the story of the equity market has been the “S&P 7” versus the remainder of the 493 names in the U.S. benchmark index. Stock market breadth, or the overall participation and strength of a broad range of stocks, is extremely weak. In fact, stock market breadth is at its lowest on record.
Source: Bloomberg
Over the first five months of the year, the market-cap-weighted S&P 500 has surged while the equal-weight index of the same stocks has fallen. The euphoria has been mainly concentrated in a handful of large-cap growth stocks, powering the market-cap-weighted index to new highs for the year. Meanwhile, the stocks that have not caught investors’ fancy lay stuck in the mud, plumbing the lows.
When one thinks of the myriad of challenges facing equity bulls, most of the fundamental and technical signals would present headwinds. Some of the factors exhibiting an obstacle for stock market bulls include:
- High probability of recession
- Persistent inflation
- Inverted yield curve
- Banking crisis
- Quantitative tightening
- Central bank rate hikes
- Declining S&P 500 earnings estimates
- Near-zero equity risk premium
There are many potential risks that could keep a rational capital allocator up at night. Nonetheless, despite the above headwinds, the S&P 500 has rallied 20% off its recent lows. What takes precedence for equity market direction, at least in the short term, is stock market sentiment.
Sentiment drives valuation and price drives narrative. And sentiment, particularly among retail investors, is red hot. The narrative of AI and its effect on productivity and technological advancement is the most intriguing since the adoption of the internet.
Bullish equity inflows, concentrated in the S&P 7, are driving the market this year. During the last week of May, the inflows to tech stocks were the highest in recent history. Demand for tech stocks was literally off the charts.
Investors are choosing tech stocks, particularly those that are AI-adjacent, at the expense of everything else. Small caps have struggled, value stocks have suffered, and many other segments of the market have been left in the dust. The Nasdaq 100, compared to the small-cap Russell 2000, now exceeds its previous peak of March 2000 (the height of the last tech bubble).
Market participants’ attention is currently highly concentrated on one particular segment of the market.
Fueling the flames of the bubble is the most uninformed of market participants – retail speculators. Through various speculative fervors in recent years, a new crop of retail investors has carried specific market segments to unbelievable heights. Does anyone remember the meme stonk craze? Stock bubbles that were heavily promoted by irrational retail traders on chat boards have typically ended in tears. Correspondingly, the shares of former and current bubble stocks GameStop, AMC, Bed Bath & Beyond, and the like, are all off more than -80% from their highs.
Retail investor optimism is at its highest level since November 2021, macro concerns be damned.
However, retail traders are only interested in a certain segment of the market. This influential contingent of stock market speculators fancies anything related to artificial intelligence. The retail fund flows into any stock AI-related have surged to unprecedented heights.
Source: FT
Retail traders are the bulls leading the charge of the rally in the S&P 500 year-to-date. And they do not particularly care for fundamentals.
You do not often hear the investment pitch, “Forget undervalued stocks. We are long the worst junk stocks that are expected to go bankrupt”, but that is what is working the best year-to-date. Over the first five months of the year, the Goldman Sachs Most Shorted Index is up +8.7%, while the Russell 2000 Value Index is down -5.0%. In 2023, mindless speculation is outperforming markedly.
In any event, in environments in which euphoria prevails with little fear to be found, junk stocks typically outperform. Bullish fund flows, based on an intriguing narrative, are pushing a contingent of the stock market to new heights.
Typically, it is in down markets in which speculative names get punished, and the outperformance of rational investing shines.
Historically, high-quality stocks underperform by 30bps in up months but outperform by 100bps in down months.
Conversely, junk stocks have outperformed by 20bps in up months and underperformed by 80bps in down months.
Imbalanced fund flows and a speculative fervour in growth stocks have led to a further widening of value spreads. The spread between the most expensive stocks and those with the lowest valuations has blown out to near-record levels. Historically, after a bubble pops, the reversion of valuations to the mean has created a tailwind for long-short investment returns.
We see stretched equity valuations, declining earnings, a bubble in certain speculative stocks, material junk stock outperformance, a negative equity risk premium, and “extreme greed” driving the U.S. markets. Stay diversified and be cautious.
If one expects the speculative bubble to deflate, which is a valid concern, it may make sense to diversify with uncorrelated or negatively correlated asset classes. While AI is an exceptional technology with vast potential, the best investment opportunity for investors may be to capitalize on the potential mean reversion of the value spread, with the view that value stocks will outperform growth as the bubble deflates.
Accelerate manages four alternative ETFs, each with a specific mandate:
- Accelerate Arbitrage Fund (TSX: ARB): SPAC and merger arbitrage
- Accelerate Absolute Return Hedge Fund (TSX: HDGE): Long-short equity
- Accelerate OneChoice Alternative Portfolio ETF (TSX: ONEC): Alternatives portfolio solution
- Accelerate Enhanced Canadian Benchmark Alternative Fund (TSX: ATSX): Canadian 150/50
ARB gained 0.4% in May while its benchmark, the S&P Merger Arbitrage Index, fell -0.8%. ARB is up 1.1% year-to-date, while its benchmark has fallen -1.2% amidst a challenging merger arbitrage market.
The Fund remains active in the SPAC market, both primary and secondary. For primary issues, there were three SPAC IPOs in May, and ARB participated in all of them. All three new issues came with an overfunded trust (average starting NAV of $10.10) with fairly attractive warrants/rights coverage. These new issues traded up 1.8% on average post-IPO. The Fund continues to cycle its capital in supporting new issues once seasoned SPACs complete their mergers or liquidate. ARB had six SPACs return capital in May and maintains a portfolio of 110 SPACs, with active trading in the secondary market to build positions below NAV and exit above NAV, when available.
The merger arbitrage market remains fraught with both risk and opportunity. As outlined in last month’s merger monitor, M&A Revolution: Riding The Wave Of Consolidation, we discussed how May 2023 featured the highest number of announced U.S. public mergers and acquisitions since November 2021. However, the regulators continue to throw curveballs at merger market participants.
In May, the FTC sued to block Amgen’s acquisition of Horizon Therapeutics, presenting a novel and vexatious antitrust challenge to companies that do not compete with each other. ARB’s portfolio management team thought that a challenge, while unlikely to be successful, could happen and reduced its Horizon position earlier in the month (although, with the benefit of hindsight, they were not prescient enough to completely eliminate it). Nonetheless, while Amgen and Horizon are likely to prevail and close their merger, the FTC lawsuit will produce a lengthier timeline and added volatility. The Fund capitalized on the volatility in Horizon shares to add back to its position it previously reduced at more attractive prices.
While the regulatory environment remains risky and uncertain, arbitrageurs can successfully navigate the choppy waters by picking their spots and being highly selective on the M&A deals they allocate to. In addition, the current merger arbitrage universe yields approximately 12.0%, so the rewards may justify the risk over time.
The Fund added six new merger arbitrage positions in May, with a total portfolio of twenty merger arbitrage allocations.
At month-end, ARB was allocated 66% to SPAC arbitrage and 34% to merger arbitrage (approximately 21% strategic M&A and 14% leveraged buyouts), with gross leverage of approximately 1.5x.
HDGE declined -5.4% for the month in a challenging month for long-short equity investing.
Multifactor long-short portfolios suffered negative performance pretty much across the board. The most difficult factors in May were value and quality. Specifically, the U.S. long-short value portfolio declined by -9.7% as overvalued stocks surged by 6.6% while undervalued stocks dropped -3.1%. It was a similar story for the long-short quality portfolios, in which low-quality stocks rallied while high-quality equities fell.
The outperformance of overvalued stocks and underperformance of undervalued equities caused the value spread (highest decile valuation less lowest decile valuation) to widen to record levels. If the value spread reverts to its mean, or at least stops setting new records, we expect HDGE to generate attractive returns as valuations normalize and the growth bubble deflates.
ONEC fell -2.9% in May as most of the Fund’s allocations suffered negative performance.
However, two allocations did garner a positive performance over the month, arbitrage and managed futures, with gains of 0.4% and 0.6%, respectively.
It was a difficult month for both hedged equity strategies and real assets. Long-short equity dropped -5.4%, while enhanced equity fell -6.9%. Meanwhile, global real estate declined by -5.3% while ONEC’s infrastructure allocation fell by -5.8%.
The Fund’s macro allocations had mixed results. While managed futures generated a positive return for the month, risk parity declined by -3.2%.
ONEC’s inflation protection bucket, including commodities and gold, had a negative performance contribution of -2.0% and -1.0%, respectively.
The private credit allocation had a smaller decline, with the mortgage portfolio declining by -0.8% and the leveraged loan allocation falling by just -0.3%.
ATSX declined by -6.9%, while its benchmark, the TSX 60, fell -5.3% last month.
The Fund’s long-short overlay portfolio produced -1.6% of negative performance. As discussed above, long-short portfolios suffered in May across the board, and Canadian long-short value portfolios were no different. While overvalued stocks were flat during the month, undervalued Canadian equities dropped by more than -5%. In addition, the long-short quality, price momentum, operating momentum, and trend portfolios all registered negative months. Long-short trend was the poorest performing factor in the month, with positive trend stocks declining -6.7% while negative trend stocks gained 0.9%.
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– Julian
Disclaimer: This distribution does not constitute investment, legal or tax advice. Data provided in this distribution should not be viewed as a recommendation or solicitation of an offer to buy or sell any securities or investment strategies. The information in this distribution is based on current market conditions and may fluctuate and change in the future. No representation or warranty, expressed or implied, is made on behalf of Accelerate Financial Technologies Inc. (“Accelerate”) as to the accuracy or completeness of the information contained herein. Accelerate does not accept any liability for any direct, indirect or consequential loss or damage suffered by any person as a result of relying on all or any part of this research and any liability is expressly disclaimed. Past performance is not indicative of future results. Visit www.AccelerateShares.com for more information.
