Analysis | ‘Full Capitulation’ Could Mean Opportunity Knocking


People are negative. Really, really negative. Now, the question is whether that could conceivably be a good thing.

It’s very unusual for big fund managers to be overweight in bonds relative to equities, and suggests deep negativity about the immediate outlook for the economy. And yet the latest edition of Bank of America Corp.’s monthly survey of global fund managers finds that they are now more underweight in stocks than bonds than at any time since March 2009, the month the stock market hit bottom after Lehman Brothers collapsed:

At one level, this is awful. The people who deploy assets for the long term think it’s better to lend to the government (at what are still very low rates) than take a share in the profits of growing businesses.

At another level, opportunity might just be knocking. This is how stocks have performed compared to bonds (proxied by the SPY and TLT exchange-traded funds) since the beginning of 2009. The previous two times that the fund management community went overweight bonds — in the wake of the 2009 crisis, and during the first Covid lockdowns in 2020 — also turned out to be historically great times to go long in stocks.

The impression of such deep gloom — that it must be overdone — continues on digging deeper into the survey. BofA regularly asks its respondents if they are taking more or less risk than usual. OK, to an extent this survey suffers from the same in-built bias as the poll that discovers a strong majority of drivers think that they drive more safely than average. Most of the time, BofA’s managers think they are taking less risk than usual, and there are times when they are wrong about this — most spectacularly in 2006 and 2007, when they thought they were drawing in their horns and taking less risk, when in fact they were still woefully exposed to the coming credit crisis.

However, it seems reasonable to assume that the survey is directionally accurate. Even if they are at all times taking more risk than they think, managers are probably right when they believe they are throwing caution to the winds, and when they feel they’re being extra careful. And they currently think that they’re taking less risk than at any time since the survey started asking the question more than 20 years ago:

The previous low on this measure came five months before the final market low, but again this could be taken as evidence that the market has already taken enough evasive action. BofA sums up the entire survey as “full capitulation.” With luck, they are right.

That leads to the issue of profits, now being announced for the second quarter. The bigger names to release results so far have shown that market is indeed on edge, with International Business Machines Corp. punished with a 5% fall, while Netflix Inc., which released numbers that could have been worse after Tuesday’s close, rewarded with  a gain of 7% in the share price.

There’s a decent shot that other companies that can avoid nasty surprises should also be rewarded this way, because investors are braced for a really bad decline in profits. Since BofA’s survey started in 1998, they have never been so sure that global profits are going to fall in the next year:

This is strange because the “consensus” earnings estimates, compiled using the numbers put out by the brokers who follow stocks and which are used to calculate prospective price/earnings multiples, are showing total resilience. As this chart from Manish Bangard of Credit Suisse Group AG demonstrates, expectations for S&P 500 earnings per share this year are higher than they were six months ago. They’re not rising, but they’re not showing anything like the negativity that comes from the top-down survey of fund managers:

Energy accounts for a chunk of this discrepancy. Exclude the energy companies, whose profits will obviously be swollen by the strong oil price, and estimates are falling. This is from Andrew Lapthorne, chief quantitative strategist at Societe Generale SA:

Analysts’ estimates for this year and next are a long way from signaling a drop in earnings, with 10.5% growth forecast for this year and 7.5% for next. But strip away the impact of the Oil sector and analysts are expecting 5.2% growth in 2022 and 8.9% in 2023, but with almost 3.0% cut from MSCI World ex Energy and Materials EPS during the last couple of months, it will not take much at the current pace of downgrading to see a decline in earnings this year.

To back this up, earnings momentum — the proportion of estimates that are being raised rather than lowered — has also weakened sharply in the last month, as the following SocGen chart shows. This has happened most dramatically in the US, probably thanks to the sharp rises in interest rates, but momentum has also dipped in Europe, the UK, and even to an extent Japan:

The interaction with interest rates also promises difficulties. With the cost of both equity and debt finance rising, analysts have no choice but to raise the weighted average cost of capital they use in their calculations. This is an unusual and unwelcome development at a time when the economy is in danger of recession:

If companies are sitting on bad news, this would probably be a good time to tell us about it. When investors are this negative anyway, it’s a good strategy to throw the kitchen sink at earnings and clean house. So there is a distinct risk of plenty more post-earnings selloffs ahead. But there’s also reason to think that the official data provided by people like ourselves might at this point be misleading. The brokers might still have relatively optimistic earnings forecasts, but money is generally being deployed by people who are far more bearish. It’s hard to be positive about the current outlook, but at times like this a little good news can go a long way.

One of the strangest and arguably positive trends under way in the US is the labor market’s steady redressing of the gap between rich and poor. The Atlanta Federal Reserve’s Wage Tracker data, compiled from census figures, show that while wages are rising fast, they’re rising far faster for the lowest-paid than for the best-paid. The Atlanta Fed splits earners into quartiles, with the lowest 25% of earners in the first quartile and the best-paid in the fourth quartile. Last month saw first quartile workers match their biggest percentage wage gains since the survey started in 1998. Meanwhile, their raises exceeded those for the richest quartile, in percentage terms, by the greatest amount on record.

For years after the Global Financial Crisis, the highest paid also managed to bring home higher raises than the poorer paid, contributing the growing sense of unfairness and inequality in society.  Somehow, the pandemic and its fallout have acted as a great leveler:

Why is this dramatic social development not creating more excitement? Because of inflation, of course. Take into account the rise in prices, and the low-paid have a less-bad deal than those who are paid more — but they still have a bad deal. In real terms, wage increases for the first quartile are roughly equal to their nadir from 2011, at -2%, while the best-paid quartile have seen their salaries fall by 5.4% after inflation:

These data require close attention. One of the biggest unspoken risks at present is of civil unrest. Lots of people have ample reason to be unhappy with the way the economy is working. The post-pandemic environment has acted to counteract a number of the inequalities that have so damaged society in recent years — but rising inflation could still negate such improvements.

Amid all the excitement in the stock market, Bitcoin is recovering. Indeed, it’s gained about 30% in barely a month. That comes after a disastrous fall, in which it tumbled far more than the S&P 500 index. None of that stopped a number of crypto-titans from showing up at Bloomberg’s crypto conference and sounding formidably bullish. Isabelle Lee offers some analysis from the summit: 

Bitcoin gives its investors a bumpy ride. Just in the last 12 months, it has gone from massively outperforming the S&P 500 to trailing the benchmark index. The world’s largest digital asset has now fallen 24% in that time frame, while the S&P 500 has slipped just about 8%.

Even so, Bitcoin’s correlation to US equities has continued to strengthen and even tends to be stronger in the midst of crucial macro events, data from Arcane Research show. Its 90-day correlation with the S&P 500 peaked at 0.655 last week, near the all-time highs from early May, Arcane added. Meanwhile, its correlation with gold — the asset that many see as being replaced by Bitcoin — remains minimal:

This implies that the latest rebound for Bitcoin, which crossed the $23,000 level on Tuesday to move out of a narrow trading range, and even break through its 50-day moving average for the first time since April, might at least have contributed to the mini-rally in equities. Despite the rampant bearishness among big fund managers, it seems that there is still some optimism in the cryptoverse:

How to explain this? It’s easy to make sense of why equities rise. The trajectory of the stock market can be determined primarily by two things: earnings per share and the price-to-earnings multiple that investors are prepared to pay for them. When shares of companies rise, it means investors’ view of the their future profits are improving — more profitability for those involved.

But what can we extrapolate from the uptrend in cryptocurrencies? Perhaps this, too, might be attributed to investor optimism on the ecosystem’s future profits. Though for now, this has been challenging to quantify save for the small number of publicly-traded crypto firms, including mining companies.

Here’s Sam Bankman-Fried, the cherubic crypto billionaire who tried to bail out firms during the industry’s implosion this year, during the…

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