When I wrote my last “Chart of the Week” post in March, the weekend news was about the acceleration of COVID-19 in the U.S. and equity futures were in free fall. This weekend, there was again news about record infection rates in the U.S.; however, equity futures are now firmly in the green.
Three factors might be driving this different reaction from the market. The first is a better understanding of the virus. We now know the age discrimination of COVID-19. Younger people with no underlying medical conditions can catch the virus but tend to show almost no symptoms or recover quickly. Also, the drug remdesivir and convalescent plasma from recovered virus patients are being widely used and have proven to be fairly effective in fighting the virus.
The second factor is liquidity. In March, investors sold in the face of fear over the virus. Now, after the extraordinary stimulus efforts from the Federal Reserve, investors are no longer selling. It seems they are simply rotating into sectors that may benefit from virus disruption. Currently, these sectors are trading at extremely rich valuations. These sectors include e-commerce, electric vehicles, pharmaceuticals and biotech. When looking at the ratio of the Nasdaq-100 Index over that of the Russell 2000 Index, it paints a clear picture. The ratio is trading at its highest level since the dot-com bubble.
As seen in this week’s chart, while the Nasdaq is marching to highs, the U.S. real interest rate is nearing record lows. The real interest rate is the market's expectation for real economic growth. A decrease in the real rate is the market saying that economic growth will be weaker. This shows the limit of the central bank — monetary policy is a crude tool; it cannot target which parts of the economy to help. The liquidity released so far has been doing more to drive the Nasdaq higher than to spur economic growth.
The last driver is the participation of retail investors, who are very active in single stock trading and single stock options this year. For single stock options, retail holdings of popular stocks are currently around 20-30% and the put/call ratio is at multi-year lows. Based on data from Citadel Securities, retail stock trading in the past was around 10% of daily volume and it is now 20-30%.
For a value-oriented investor, there are plenty of stories that give me pause about valuations in the technology sector. I’m wary of the popularity of blank-check companies, a stock rally whenever a company mentions some news about electric vehicles and the extreme richness of defensive/high-quality companies compared to the extreme cheapness of cyclical/lower-quality companies. None of these trends are indicative of the economy getting better. They are the results of an abundance of liquidity and the lack of alternatives.
Even though the market is rallying every day, market expectations for economic growth have been deteriorating since early June. The tech sector is benefiting the most from central bank liquidity and retail investor participation. It is hard to know when this will change and what will trigger the change. Now it is more important than ever to have a balanced portfolio with a good mix of domestic and foreign stocks, growth and value names, as well as deflation and inflation hedges.
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This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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