Lee Adaptive Strategies Update
The bulls scored a moral victory over the bears in May, with the S&P up 0.18% on a total return basis. For the first five months of the year it is down -12.76%.
This very modest triumph of the bulls was due entirely to a single glorious week. Over the five days that led up to the Memorial Day holiday the index gained 6.62%. At the close the Friday before, the S&P had been down -18.19% from its January 3rd high, just a bad day away from being down 20%, which television pundits tell us makes an official bear market.
We wince whenever definitions and characteristics of bear markets are discussed. It is not that we do not believe that bear markets exist as a phenomenon, or that the events of previous bear markets do not contain lessons for future bear markets. On the contrary, our belief in market momentum includes a belief in self-perpetuating falling markets as well as rising ones. And lessons of the past contain much wisdom if thoughtfully applied.
Our issue is that although they have similar characteristics in the most general sense, every bear market is unique. Declaring a market downturn to be an official bear market feeds into the human tendency to read history too literally and to expect a predictable narrative to follow the bear market diagnosis. In contrast, we think one of the best observations to be made from studying previous downturns is the absence of a script. There is no such thing as a generic bear market.
For example, it is often thought that bear markets are marked by a period of panic. The brief bear market of early 2020 certainly centered on fear and uncertainty over the arrival of COVID. And the 2007-09 downturn had as its most memorable episode a financial crisis brought on by the collapse of Lehman Brothers. But that original “Lehman Moment” was just one chapter in the bear market’s story, occurring more than a year after stock markets peaked and about half a year before they bottomed out.
Moreover, the 2000-03 decline did not have a memorable period of panic. It may be called the Dot Com Bubble in retrospect, but it was a bubble that did not pop but rather deflated gradually over several years.
Memory tends to generalize the past. Bear markets are remembered as being much simpler than they actually were, with tidy causes and resolutions. The language we use suggests that bear markets “correct” the mistakes of bull markets, that the bear markets return us to the true path.
So the bear market at the beginning of this century was due to an irrational exuberance at the end of the previous century, which drove technology stock valuations to unsustainable levels. That was resolved in the obvious way, with a massive, if slow, price correction. And yet, in retrospect that correction was arguably a mistake. Apple, Google, Amazon, and Microsoft turned out to be great investments over the following two decades. Even their 2000 peak valuations look like once-in-a-lifetime bargains today.
The bear market of fifteen years ago is similarly thought to have been caused by a housing bubble exacerbated by a flawed financial system. The bear market ended when house prices returned to normal and the financial system was reformed. But house prices are today much higher, even after adjusting for inflation, and Wall Street, including especially the mortgage market, operates largely as it did before the crisis.
The recent miniature bear market of 2020 may seem particularly explainable in both cause and resolution. There was a terrible disease, which caused panic in the markets and a recession. The pandemic turned out to be not so bad and the markets and economy quickly recovered.
But perhaps that narrative is naive. The driver of the current bear market (assuming it qualifies as one) is primarily the Fed’s reaction to inflation brought on by a historic increase in the money supply, as well as global commodity shortages and logistical problems. All of which are attributable to the very same pandemic that gave us the 2020 bear market and recession.
In a meaningful sense, this bear market (and we suspect it is a bear market, regardless of what the television reporters tell us) is Part Two of the pandemic bear market. The measures taken in 2020 in the US and globally to fight COVID, a profound lessening of economic production while maintaining approximately the same level of consumption, can only be very expensive. Printing and giving away unimaginably large sums of money may have been the correct policy response, but it does not replace lost economic activity. Sooner or later, we will have to pay the piper, something that is apparently only slowly becoming apparent to many investors.
The Market Sentiment Framework
We use our Market Sentiment Framework to adapt the mechanics and weightings of our full quantitative models to changing market conditions.
The Sentiment Framework gauges the current state of market psychology on two dimensions. Efficiency measures the crowdedness of the market, the volume of participants seeking investment opportunities. Lower levels of efficiency imply more market mispricing. Optimism measures the willingness of investors to take on risk in exchange for distant and uncertain rewards. Higher levels of optimism imply a better outlook for risky asset classes.
Optimism declined in May, while Efficiency rose somewhat, but still stayed within the range it has inhabited for six months.
Optimism began the month at -0.60 and ended at -0.90. It has decreased steadily since mid-2021 and is now approaching levels last seen in the summer of 2020.
Efficiency rose modestly, starting the month at -0.39 and ending at -0.25. Efficiency continues to be comparatively low as compared to historical averages, which suggests a market that is under stress. It has, however, not fallen to the levels typical of a market dislocation.
Both measures are higher than where they were in early 2020, but have trended lower over the past year. The current positioning of the Sentiment Framework implies a market that is functioning less than ideally, with increasingly fearful investors. This would imply a challenged outlook for the market as a whole, but possibly an opening for value strategies to find opportunities.
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