A disturbing divergence in market outlooks has emerged in recent weeks, as US retail investors scramble to allocate more cash into the stock market, even as institutions sound the alarm and warn that price gains for the coming quarter will be limited.
After the best quarter for the S&P in 5 years, retail investors have flooded back into stocks, drawing down cash balances at brokerage accounts to record lows even as strategists at big banks from Goldman, to Citi, to Morgan Stanley and JPMorgan have recommended fading the rally in American stocks while forecasting the second-weakest year-end period of the market’s now-record long bull run. And, as we enter Q4, sellside analysts, traditionally cheerleaders for further market gains, look “timid”, and according to the average year-end S&P 500 target of 2,956, they forecast just a 1.4% gain in the fourth quarter. That would be the worst close to a year since 2012.
The story is familiar: “alarms are ringing” across Wall Street as Bloomberg puts it, as strategists continue to warn over peaking growth, trade tensions and stretched valuations. As a result, institutional and professional investors are hunkering down in anticipation of what comes next. Two weeks ago, we reported that Morgan Stanley’s hedge fund clients slashed the net exposure and leverage to the lowest level this year, a sign that risk appetite is retreating, just as the market pushed on to new all time highs.
Even one of the biggest bulls on Wall Street, BMO’s Brian Belski, has refused to raise his year-end price target of 2,950 for the S&P 500 amid concern that investors may have flocked to stocks in anticipation of a year-end rally that could be delayed by the political turmoil in Washington and the mid-term elections.
“Given the strong momentum of U.S. stocks, many clients have asked why we have not become more optimistic,” Belski wrote in a note Thursday. “We believe investors may have already ‘pulled forward’ any anticipated post-midterm election bump.”
Traditional mid-year election comparisons have also flown out of the window. According to Belski’s calculations, in midterm years the market starts the year slowly before rallying in the final quarter, with the final three months delivereding on average gains twice as big as those in non-midterm years. Needless to say, this year has been an outlier, with the S&P starting off January with a blow-off top, then suffering a near correction in February, before rallying another 9% through the end of September, “compared with an average loss of 1.7 percent at this time in midterm election years.”
Historical patterns aside, strategists are also concerned about the accelerating pace of Fed tightening and balance sheet shrinkage, which this quarter will ramp up by another $10 billion and hit a peak $50 billion a month as Treasuries and MBS holdings mature.
With earnings forecasts still on the rise and the Federal Reserve in no hurry to slow the pace of tightening, the market is unlikely to repeat the same pace of gains in coming months, according to John Augustine, chief investment officer who helps oversee $17 billion at Huntington Private Bank in Columbus, Ohio.
Meanwhile, stocks are hardly cheap, trading at 16.8x forecast earnings, a multiple that’s 14% higher than its 10-year average. Worse, according to Goldman Sachs, the market is not only “expensive on most metrics”, it is in the 89% percentile of aggregate overvaluations, while on a median basis when looked at traditional valuation metrics, stocks are more expensive than 97% of all historical observations.
“We’re probably seeing the peaking moment in the economy and earnings growth,” Augustine said. “Does it mean markets deteriorate? No. But stocks probably have done their bulk of work this year.”
Yet despite Wall Street’s warnings, retail investors not only ignore the tales of caution, but have become increasingly oblivious to any downside risks, in a repeat of what happened at the start of the year when the S&P 500 suffered its worst correction in two years.
As a result, retail investors have poured into the market as confirmed by the record low levels of cash at retail and discount brokers such as Charles Schwab, where cash as a percentage of client assets fell to 10.4%, matching the record low level reached in January (back then, just a few days later, the S&P plunged as a result of the VIXplosion that wiped out inverse VIX ETFs and countless vol sellers).
The main difference between January and now is the growing divergence between professional investors, who are growing more pessimistic by the day, even as retail investors refuse to slow down their ETF-buying ways which in turn continue to “lift all boats.”
To some, such as David Campbell of San Fran-based BOS, the lack of consensus is good news for American stocks.
“I don’t really worry about markets when there is a lot of skepticism. I worry about markets when I don’t see anybody being skeptical,” Campbell told Bloomberg. “The longer bull markets go, the more people who have been sitting on the sideline feel like they’re missing out. So there is built up pressure to give in and participate.”
Of course, with record low cash in brokerage accounts, the purchasing power on the “sidelines” have never been less.
As for the who is proven right in the end, professional or “mom and pop” investors, in a world in which such former hedge fund titans as David Einhorn are now down 26% YTD, it has become virtually impossible to assume that just because they are “less informed”, retail investors will lose.
At the same time, one can make the argument that what we are seeing now is institutions and insiders simply dumping to euphoric retail investors at a record pace that suggests the manic phase is almost over.
And when looking at the historical record, every time this process reached its inevitable end, the rug would be pulled out from under the market, at which point the furious retail liquidations began as institutions once again stepped in and the cycle would repeat itself. There is no reason why this time should be different.