- A gauge of the bullish stock-market wagers made by institutional investors like pension funds and insurance companies has exceeded the highs it reached before the 2008 financial crisis.
- This “euphoric positioning” is now signaling that stocks are in the process of forming a top, according to RBC Capital Markets’ Lori Calvasina.
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Even bulls on Wall Street are now uneasy about the stock market’s seemingly unstoppable rise over the past few weeks.
One of them is Lori Calvasina, the head of US strategy at RBC Capital Markets, who says the rally has firmly entered “euphoric” territory.
She’s not basing this observation simply on the fact that stocks roared into the end of 2019 and capped off their second-best year of this bull market.
Rather, she sees proof beneath the market’s surface showing that this rally resembles previous market tops — including the lead-up to the 2008 financial crisis.
One of the gauges she’s watching is derived from futures-market positioning data supplied by the Commodities Futures Trading Commission. But we aren’t talking about what amateur speculators are doing: the data represents the trading activity of big investors including pension funds, endowments, insurance companies, mutual funds, and portfolio managers who predominantly serve institutional clients.
The chart below shows their net-long positioning, meaning how much they have staked on bets that the stock market will rise in excess of bets that it will fall. The near-vertical line on the far right that represents the surge in net longs over the past few months is unmistakable.
RBC Capital Markets
Calvasina attributes this spike to a ‘fear of missing out’ that gripped investors late last year when the recession fever they developed over the summer vanished.
But even before the so-called Santa rally, she had observed that net-long positioning reached peaks that were associated with the market tops throughout 2018 and 2019.
The pre-financial crisis top is now on that list, too.
“While it’s tempting to say the market is breaking out of the rut it’s been trapped in for the past few years, when we dig down into the details we come away even more convinced that a positioning peak is in the process of being made,” Calvasina said in a note to clients.
Her year-end forecast for the S&P 500 is 3,460, which is above both the average and median of 20 of her counterparts at other firms computed by Bloomberg.
And so ultimately, she expects stocks to continue rallying — by 6% this year, based on the starting position of the S&P 500.
But on the way towards that target, she is bracing for a year of turbulence.
On top of the euphoria that’s apparent in futures positioning, Calvasina flagged valuation as a reason why the ongoing rally could soon be stopped in its tracks.
Instead of picking one metric, she combined 34 — including the price to earnings, price to book, and price to cash flow ratios) — into a single model.
“As of December 31, 2019, this model hit 1.55 standard deviations vs. its long-term average, breaking through the ceiling that has been in place in the current cycle,” Calvasina said.
She added, “At current levels, it is in a range historically associated with 12-month forward returns in the flat to low single digits.”
If you’re looking for reasonably valued parts of the market to invest in, consider financial and industrial stocks. Relative to the S&P 500, Calvasina says, these sectors are deeply undervalued. Financials are particularly attractive because they are the cheapest among sectors with high dividend yields and consistent buyback announcements.
Additionally, Calvasina recommends selling stocks in the “slightly expensive” consumer discretionary sector to fund purchases in the aforementioned areas of the market.