One More Night

I have a confession to make: I love reality TV, and the trashier the better. After a long day traversing the globe generating alpha, there’s nothing quite like kicking up your feet with a glass of Kentucky water and watching women fight over whose Birkin bag cost more. I was indulging in my guilty pleasure recently when I saw a commercial for an upcoming show called A Night with My Ex.

Seriously, can you think of anything worse than spending a night with your ex while the cameras roll and hundreds of thousands of viewers witness the whole thing? Those people are going to discover that it always turns out like the Maroon 5 song One More Night. They’ll wake up hating themselves.

I’m definitely recording that show, but luckily I don’t have to wait until July to get my fix. That’s because right now investors are making a Night with My Ex-type mistake in U.S. equities, and I’m bearing witness.

 

I Stopped Using My Head, Using My Head

First off, I don’t understand why everyone seems to be waiting for the other shoe to drop while the S&P and Nasdaq continue to clip brand new all-time highs, and U.S. small caps sit just a stone’s throw away from their ATH.

The crazy thing is that it’s not just doomsayers dressed up as financial analysts, like our boy on bubble watch Graham Summers, who are calling for the Big One as if they were Fred Sanford.

Even perma-bullish Wall Street has joined the doom-and-gloom party.

JP Morgan is calling for a 10% correction based on the belief that a combination of inflation rolling over and a future “soft patch” in global growth will stop the S&P 500’s ascent. Bank of America believes there could be a 13-20% downside risk based on the way U.S. yields have traded this year.

I hate to break it to the doomsayers, Wall Street and anyone else anticipating at least a 10% correction in U.S. equities, but neither history nor the current trajectory of the U.S. economy backs your play.

Since 1928, the S&P 500 has only experienced a 10% drawdown in 1% of all months and 7% of all three-month time periods. Suffice to say, it’s rare for the S&P to have a drawdown of that magnitude. In fact, you have a better chance (one in 11) of being called to “Come on Down” on The Price is Right!

What’s more, not one of those 10% declines occurred during a period of accelerating U.S. economic growth. That’s right folks; a big fat donut. However, investors are clearly ignoring history and heeding the caution of Wall Street.

In the S&P 500, long exposure has been declining ever since it peaked in late February. Meanwhile, shorts have been increasing, leaving investors long America’s favorite benchmark, but only by the slimmest of margins.

In the Nasdaq, investors started reducing their historically long positioning last summer, and shorts have been building since October. This leaves positioning in the Nasdaq 100 also long, and also by the slimmest of margins.

In the Russell 2000, investors are actually net short! Long positions have been declining since their peak right after the presidential election, while shorts have increased to the highest level in over three years.

I can understand taking some money off the table if you’ve been long the S&P or Nasdaq for a while. But I can’t understand for the life of me why anyone would be short U.S. small caps, and increasing that short exposure, in the midst of an economic environment in which U.S. growth has been accelerating for eleven months and counting.

 

I Know I’ve Said It a Million Times

You don’t ever trade a market in a direction counter to its Fundamental Gravity. Period. For the uninitiated, a market’s Fundamental Gravity is dictated by the growth, inflation and central bank policy of the market’s underlying economy. Nothing impacts asset prices more than economic conditions and the way central banks respond to those conditions.

U.S. growth has been accelerating since it bottomed last June. The official calculation for Q1 2017 GDP backs up this statement, and the data from April and May indicate that the growth trend remains intact for Q2.

From an economic perspective, industrial production is sitting at a 28-month high and has accelerated for five straight months. The annual pace of U.S. productivity has accelerated for four straight quarters and is sitting at the fastest pace in the last two years. Not only that, but even though the U.S. economy is extremely late cycle, the labor market continues to hum along, creating new jobs at a nice pace.

To top it all off, U.S. corporations just experienced their best earnings season in 13 years.

The bottom line is that the U.S. Fundamental Gravity is extremely bullish for U.S. equities, especially high growth sectors.

In the last 12 months, U.S. technology stocks have gone up 32% and experienced a 6% drawdown. U.S. small caps have gained 20% while experiencing an 8% drawdown.
Meanwhile, U.S. utilities have gained just 12% with a 12% downside risk, and long-dated U.S. Treasuries have actually declined 3% and experienced a maximum drawdown close to 18%. Ouch!

My friends, Fundamental Gravity is the reason that stocks from Silicon Valley have outperformed Treasuries by 3,500 basis points with one third of the risk, and nearly tripled the return of utilities with half the downside risk.

 

I’ll Wake Up, Probably Hating Myself

The bottom line is that expecting a severe correction in the U.S. stock market, much less an actual crash, during a period of accelerating growth will leave you hating yourself.

Best case, you’ll miss out on great risk-adjusted returns, such as those delivered by tech stocks. Worst case, you’ll join the uninformed who are currently shorting small caps, and get your face ripped off playing Captain Market-Top Caller.

Rather than joining the flock and making your own Night with My Ex-type mistake, stay data dependent, process driven and risk conscious.

The data say U.S. growth is accelerating. The process says that when growth is accelerating you should be long, strong and down to be as long U.S. equities as your risk tolerance will allow. And risk consciousness says that you should favor tech and small caps over slow growth assets like utilities and Treasuries.