Given the abrupt halt to the US and global economies, it appeared inconceivable back in March that the stock market would have recovered all its losses – and an unbelievable 10% gain by August. Yet here we are.

While delighted with this performance, we have real concerns around current market dynamics and just how high trees can grow.  Our homebound lifestyle has made technology, communications, and consumer discretionary sectors far and away the leaders of this rebound.  We expect this trend to continue as this group has advanced 30% for the year, while the rest of the market is down.  As money continues coming into the market (more on that below) – these sectors are attracting a great majority.  We believe there will ultimately be a major shift towards the most disaffected areas of the market once we can envision the economy fully reopened – whenever that may be.  

While the thesis of working and shopping from home that drove these sectors is still valid, the forces truly driving prices are momentum and the dearth of other places to get positive short-term gains. With interest rates near zero, high bond prices and the Fed signaling it wants inflation, alternative places to invest look less compelling.  So, the concentrated advance of these sectors is likely to continue.

Until It Doesn’t.  

While the economy is in fact recovering, it could be two years for corporate earnings to match 2019 levels, let alone justify today’s stock prices. We have stated before that valuations themselves are a terrible timing tool, but history shows that when we reach 22x expected future earnings, trouble looms.  

Confirming this dynamic are some of the more technical indicators that we monitor.  Breadth (the % of stocks taking part in the advance) is waning.  While markets advanced 7% in August, less than half of all stocks were up – only the 12th occurrence in 30 years.  While some measures of investor sentiment are bullish, others are not.  Most telling is the ratio of put options to call options; now at the lowest level since the “dot com” bubble.  None of these alone signals impending volatility but given the leverage of excessive call buying any catalyst that disrupts this optimism will result in exaggerated short-term volatility

Furthermore, September is historically the most volatile month of the year, and coupled with the election, we are vulnerable to some form correction in the next few months which, if it occurs, we expect will be short and shallow.  

Given these observations, we are positioning to take some gains off the table and utilize a hedge that appreciates with increased market volatility.  We expect to maintain this position for only a few months and will continue monitoring market dynamics. 

We could very well be wrong: similar conditions have happened before, even at current levels, and markets continued to rally.  But with Main Street reality very different than Wall Street reality, we believe a little defense at this time is warranted.

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