The Pain Trade
Earlier this year, I described many points which investors faced and last quarter that there may be weakness in the market. Significant points were:
- Inflation expectations
- When will the Fed lower their interest rate targets
- Impending recession
- Geopolitical risk
- Uncertainty surrounding the 2024 U.S. general election
Currently, these points have been somewhat muted for the moment which may have prompted some of the over $5 trillion in money market funds to chase the market. The chasers are predominately short-term traders and unsophisticated investors which identify the stock markets more as a gambling tool rather than a mechanism for long-term growth. The weakness in the market has manufactured itself in an unusual, bifurcated fashion with larger companies gaining and smaller companies going backwards. In a more dramatic fashion, one could isolate the gains to the mega-cap ‘Magnificent 7’ cohort of Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla. Within the major indices the NASDAQ index represents these names the most.
During the second quarter of 2024, the S&P 500 Index gained 3.9%, the NASDAQ Index gained 8.3%, the Russell 2000 Growth Index was down 3.1%, and the iShares Barclays 7-10 yr. Treasury Bond ETF (IEF) lost 1.1%.[1]
When the market is chased, money is usually driven to companies which have a good story and are moving up, respectively called “story” and momentum or “momo” stocks. This is like investing in widgets which may or may not be on an actual fundamental basis and can carry a lot of volatility. One such company with a fantastic product offering is Nvidia (NVDA). It provides hardware to the AI market.
Even with the beloved Nvidia there is volatility and timing was everything in the second quarter. Despite NVDA’s year-to-date overall gain, an unlucky trader could have experienced a 16% loss due to timing. There are a couple of takeaways from NVDA and the bifurcated market returns in the quarter.
The first is that the major market indices are producing skewed returns from a composition biasing larger name returns. Second and more importantly is that an overall market correction may be surfacing with indications from the negative smaller name returns. Unless there is a sudden or “black swan” shock to the market, traditionally corrections begin with weakness in the smaller names, and it concludes when the larger sought after names succumb.
Before I go any further, I do not foresee a calamity in the stock market.
I do continue to expect a period of weakness prior to the election. As the summer months progress, usually trading slows, which creates less liquidity-the degree to which an asset or security can be quickly bought or sold in the market without affecting the asset’s price. With the high probability of increased uncertainty due to my initial points expressed above, especially with the election coming, investors might be sent to the sidelines. Without investor demand, there are fewer willing buyers to match up against any selling and a more wide-spread correction may ensue regardless of whether a company’s fundamentals are good or bad.
When investors, or participants in any market, find themselves unknowingly complacent thinking this is easy, this is when “The Pain Trade” comes in. The Pain Trade definition by Investopedia is:
The tendency of markets to deliver the maximum amount of punishment to the most investors from time to time. A pain trade occurs when a popular asset class or widely followed investing strategy takes an unexpected turn that catches most investors flat-footed.
Complacency may currently be the result of the Fed pumping trillions of dollars into the financial system to smooth over any potential economic disturbances. What can change complacency is uncertainty. The stock market hates uncertainty! Due to COVID, Fed spending, illegal immigration, poor and biased reporting and politics, among many other factors, it is hard for anyone to develop a clear picture of economic truth.
Data I have been monitoring lately, which could lead to uncertainty in the markets, is the three-month moving average of the national unemployment rate. Since 1960, if the national unemployment rate rose by 0.50 percentage points or more, relative to its low during the previous 12 months, a recession has occurred. This indicator is known as the Sahm Rule which was developed by former Fed economist Claudia Sahm.
On July 5th with the June 2024 U-3 unemployment rate release of 4.1 percent, the average of the last three months being 4.0 and the lowest 12-month rate of 3.5 percent in July 2023, this criterion has been met. So far, the market has ignored this fact, but it certainly could be a catalyst for market uncertainty. This number has been developing for months and kept me closely monitoring client risk and areas of stock allocation.
If uncertainty creeps into the market, I expect the market to react similarly to how it has in the past. This would mean stock market darlings which exhibit rich valuations to drop as new information is digested into the market. To the traders and short-term investors, this will be the Pain Trade.
The depth of a widespread correction will depend on the specific news that triggers it and how long it lasts. As corrections conclude, many times investors are more open and looking towards the markets that are the cheapest and best to exploit. One successful tool used for this by institutional investors is called the Reversion to the Mean strategy which suggests that variables eventually revert to their long-term average levels.
The following graph depicts that the small-cap Russell 2000 Index Total Market Cap compared to the large-cap S&P 500 are at an extreme divergence. “Cap” refers to a company’s capitalization = no. of shares x stock price.
To correct this divergence, three -factors could happen to bring the ratio back to the average:
- The S&P Total Market Cap drops
- The Russell 2000 Total Market Cap increase
- Both 1 and 2 occur, which is what I would expect to happen in some fashion
Intuitively, a reversion to the mean between small and large company valuations makes sense since the smaller ones have been sold for the opportunity to jump on the large company bandwagon. In large, I am talking about the Mega Stock bandwagon. As I wrote in my last letter, I explained how many stock market darlings fizzled for many years after the 2000 correction. While there may be pain in the non-Mega Stock arena, I believe that is where the true opportunity exists today.
As always, I will be vigilant in following and assessing changing developments to take advantage of new ideas and minimize risks as I see them.
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[1] These returns are price based and exclusive of dividend reinvestment. Return data provided by QUODD Financial, ETFreplay.com, and Yahoo Finance