The Pessimistic Rally

In the last market letter we discussed how we were embarking on the most profitable time of the year in terms of market returns. And so far, that seasonality trend has played out. The S&P 500 rallied over 8% in November and the broader markets are nearing their all-time highs, but still investors remain overwhelmingly bearish. From looking at market sentiment data and put/call ratios, it remains clear that investors are still betting on, and waiting for a market crash. Granted, small-cap stocks are still well below their peak, off nearly 25%. And high-tech innovation funds that were all the rage during the pandemic are still down a dramatic 70% from those vaulted valuations. The Nasdaq and S&P, however, are a mere 2% away from where they were at their peaks in January of last year, implying that much of the bearish sentiment seems unwarranted. Betting against this market is weighing on the returns of many small investors and large institutions alike. Especially those not invested in large-cap tech names, which have been the darlings this year. The likes of Google, Apple, Meta (Facebook), and Tesla have helped push the Nasdaq index up over 45% so far in 2023.

There will always be reasons to worry or doubt a market and this year has been no different. Interest rates are near 15-year highs, inflation has been soaring to levels not seen in decades, wars broke out on multiple fronts, and a looming recession was promised by year-end. But somehow investors and many market commentators missed one of the most important fundamental drivers of the market – earnings. Earnings in the S&P 500 have risen over 8.8% to new record highs. When earnings go up, typically stock prices go up too. And why wouldn’t they? Charles Munger, the famed and brilliant investor famously said to his longtime partner Warren Buffet at Berkshire Hathaway, “If people weren’t wrong so often, we wouldn’t be so rich.” Sadly, he passed away a few days ago but he left us with a tome of invaluable wisdom. He was an expert on human behavior and how it relates to business and investing. Behavioral economics is something we take very seriously at HWM, especially investor misbehavior. We use this to our advantage quite a bit. Twelve months ago, market strategists were forecasting a down year for stocks and the largest commercial hedges (bets) on record were placed for that to happen. We read: institutions are selling now so they can buy later. Fast forward to today and lo and behold, they could not have been more errant with their bet. All that money that was placed on the wrong side of the trade had to either unwind and enter the market or watch their options decline in price or go to zero.

It’s hard to go against consensus, but it’s also one of the few proven ways to consistently make returns in a chaotic marketplace. Cash levels alone tell us that investors are still very pessimistic, if not outright scared of being in the market. There is currently close to $6 trillion of US investor money sitting in money market accounts. With yields of around 5.25%, it’s not the worst place to hide out. Eventually sentiment will shift, either because rates will fall or investors will simply grow frustrated missing out on double digit market returns, and all that money will come flooding back into stocks. Happy holidays.