December 16, 2024 – As investors priced in prospects of deregulation and a fresh focus on economic growth, markets surged, allocator optimism skyrocketed, and stock market fund inflows swelled with market participants cheering the election of Donald Trump.
An upcoming change in the U.S. administration had an abrupt effect on the stock market. In November, stock market optimism jumped to a record high, with the share of households expecting U.S. stocks to rise next year reaching unprecedented levels.
Bullish narratives and the fear of missing out (FOMO) have compounded investor behaviour, causing more market participants to hop onto the momentum bandwagon. This dynamic has created a positive feedback loop in the purchasing of securities.
As investor optimism surged, capital flows have followed, and last month featured a record $140 billion of net inflows into U.S. equity funds. Record inflows often amplify momentum, as investors chase recent winners, creating a self-fulfilling cycle of rising prices.
Record optimism and unprecedented investor inflows into the stock market can significantly impact forward returns, primarily by inflating valuations, increasing volatility, and setting unrealistic expectations. For example, given the exceptional recent performance of the S&P 500, particularly over the past two years, many new investors are conditioned to expect consistent double-digit returns from stocks.
Heavy inflows have driven up stock prices, especially in favoured sectors and asset classes, regardless of the underlying fundamentals. Record inflows have concentrated in trendy sectors, creating potentially crowded trades.
The current trendy market segment is U.S. large cap equities, where record investor inflows have come at the expense of nearly everything else. Over the past several weeks, as U.S. equity fund inflows enjoyed their strongest stretch ever, international funds saw a steady drumbeat of outflows.
The difference in investor optimism between U.S. and international stock markets could not be more stark. As investors have shunned international stock markets, the valuations within this pocket of the global market have remained reasonable. Meanwhile, global investors’ penchant for a piece of the U.S. large cap growth story has pushed domestic stock prices to rich levels. Currently, the S&P 500 trades at 23x forward earnings, a nearly 60% premium to global stocks (as measured by the MSCI World Ex-US Index).
U.S. stock valuations are not only elevated compared to international equities, but they are also high compared to their own historical average valuation of around 15x forward earnings.
The S&P 500’s current valuation of 23x forward earnings has only happened twice in history, between 1998 to 2000 and in 2021. Both times, a painful bear market followed shortly thereafter.
That said, there is no denying that U.S. corporations have displayed fundamental exceptionalism over the past several years. Strong operating performance from seemingly unstoppable companies such as Nvidia, Alphabet, Amazon, and Meta, have powered earnings growth of the S&P 500 far beyond the stock markets of other countries. U.S. markets are where the earnings growth has been, and where AI and the hyperscalers reside. Investors predictably want a piece of this action. This in-demand AI and AI-adjacent exposure is not as readily available in markets such as Europe or Japan.
Nevertheless, investing is not so easy. It is possible that the optimistic narrative of artificial intelligence has led to a situation of potential overexuberance, in which investors bid up stocks to unsustainable levels while ignoring risks. This high level of optimism can lead to the risk of an abrupt shift in sentiment when these lofty expectations priced into the market are not met, increasing volatility which may lead to a swift market drawdown.
Highly valued markets become hypersensitive to micro and macro results coming in below expectations, with earnings misses, interest rate hikes, or geopolitical events creating catalysts for stock market corrections.
U.S. markets carry valuations far beyond not only their international brethren but also their historical average. In contrast, diversified investors can find far more reasonable equity valuations in places such as Japan, Europe, and emerging markets.
Empirical data show an inverse correlation between investor sentiment at extremes and subsequent stock market returns, with forward returns lower on average when sentiment indicators and valuation measures are excessively bullish. Conversely, periods of extreme pessimism and low stock market inflows (or even outflows) often precede strong forward market performance. One would be hard-pressed to find overly bearish behaviour in today’s stock market.
While record stock market optimism and equity fund inflows reflect strong investor confidence, these dynamics often precede periods of muted forward returns due to elevated valuations, a misallocation of capital, and heightened market fragility. While this concern is no reason to exit the stock market entirely, investors should do their best to fight the FOMO and remain prudent, focusing on diversification and keeping long-term objectives in mind during such exuberant periods.
Sometimes, it feels like a fool’s errand to remain diversified during strong bull markets (“You mean to tell me your portfolio is not just 100% MicroStrategy + bitcoin, up 300% this year?”). Having a broad-based allocation to a diversified stream of uncorrelated returns that will likely create consistent investment performance with mitigated drawdowns, which remains a logical approach for rational investors with a long-term mindset.
Accelerate manages five alternative investment solutions, each with a specific mandate:
- Accelerate Arbitrage Fund (TSX: ARB): Merger Arbitrage
- Accelerate Absolute Return Fund (TSX: HDGE): Absolute Return
- Accelerate OneChoice Alternative Portfolio ETF (TSX: ONEC): Multi-strategy
- Accelerate Canadian Long Short Equity Fund (TSX: ATSX): Long Short Equity
- Accelerate Diversified Credit Income Fund (TSX: INCM): Private Credit
ARB gained +0.4% while the benchmark S&P Merger Arbitrage Index fell -0.8% for the month.
The Fund added five new merger arbitrage investments, out of fourteen total deals announced. Eleven of the Fund’s merger arbitrage investments were completed successfully last month, while one deal was terminated (Tapestry’s acquisition of Capri), which cost the Fund -0.2%.
In addition, the Fund added one new SPAC IPO to its portfolio out of a total of nine new blank checks that came to market.
Currently, ARB is 129.3% long and -7.7% short (137.0% gross exposure), with 54% allocated to SPAC arbitrage and 46% to merger arbitrage.
We are pleased to announce that ARB was awarded a top 10 global performance ranking in BarclayHedge’s October hedge fund rankings in the merger arbitrage category.
With the significant gain in optimism and the surge in risk assets, November was a difficult period to hold hedged portfolios. The Goldman Sachs Most Shorted basket jumped +13.2% in a painful month for short sellers. The long short equity proxy, represented by the GS VIP Index minus the GS Most Shorted basket, fell -5.6%.
Nonetheless, HDGE eked out a +4.0% gain despite a challenging market for long short equity strategies. The Fund’s short portfolio risk models worked overtime to mitigate risks.
Multi-factor portfolios held up generally well throughout the month. As short baskets surged, most long factor baskets rallied in tandem, aside from the long-short momentum portfolio, which experienced losses in both the U.S. and Canada.
The Fund’s top three monthly winners include long positions in AppLovin, Griffon, and Doximity, while its top losers were short positions in Paragon 28, Stratasys, and Altus Power.
ONEC returned +2.2% in November as most alternative asset classes generated positive performance.
The Fund’s infrastructure allocation was the top contributor, surging +5.7%, followed by long short equity, private credit, and absolute return, which generated returns of +4.8%, +4.4%, and +4.0%, respectively.
Both the managed futures allocation and the leveraged loan portfolio added +1.0%. Risk parity and arbitrage rounded out the positive contributors with monthly returns of +0.8% and +0.4%, respectively.
Detractors for the month include the commodities allocation, which fell -1.1%, and gold, which dropped -3.1%.
ATSX returned +4.8% while its benchmark, the S&P/TSX 60, gained +6.7%.
Multi-factor performance was more difficult in Canada, with the broad Canadian long-short multi-factor portfolio falling -3.6% in November. While the value, quality, and operating momentum long short equity portfolios were approximately flat for the month, losses came in the price momentum and trend portfolios where the shorts surged, and the longs could just not keep up.
The Fund’s top three monthly winners include long positions in Nuvista Energy, CES Energy Solutions, and iA Financial, while its top losers were short positions in CAE and Energy Fuels, along with a long position in Silvercorp Metals.
INCM provided a total return of 4.4% last month, as private credit yields remained high and NAV discounts continued to recover.
Third quarter reporting for the universe of liquid private credit vehicles (BDCs) occurs throughout November. The recent Accelerate Liquid Private Credit Monitor noted that Q3 results were generally good, with loan portfolio values and yields remaining relatively consistent. Non-accruals and payment-in-kind loans also remained stable, a signal of solid credit quality.
Currently, INCM’s portfolio is allocated to 20 private credit funds, representing 4,754 underlying loans and investments, of which 86.5% are senior secured loans and 92.8% are floating rate. The underlying INCM portfolio yields 11.4% and trades at an aggregate -1.4% discount to NAV.
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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.
