Henny Penny and the Risk Amplifiers

Last Friday’s SARS-CoV-2 “variant of concern,” Omicron, rout sparked a lot of comparisons to March of 2020 over the weekend.

It is difficult to predict the potential economic disruption given very little information on the variant (we know the variant has more mutations, critically in the spike protein that interacts with vaccines; but it is too soon to know about transmissibility, severity of disease, vaccine evasiveness, demographic vulnerability and more).

Instead, I have been thinking a great deal about how different today’s market and economy is compared to the pre-COVID market of January 2020, and how these differences could influence how the market reacts to future risks (be they COVID related or not).

Compared to January 2020, today we have higher valuations, higher trader leverage, higher stock allocations, more ebullient sentiment, higher inflation (potentially boxing in central banks) and likely less political will to step in and stabilize economies with spending. On the upside we have still ample liquidity, high cash balances for consumers and companies, better corporate balance sheets and a FOMO eagerness to buy any dip.

Could any of these negative differences cause markets to be more fragile when a real risk (that may or may not be Omicron) presents itself?

Could any of the positive differences help insulate markets from shocks (high cash balances and eagerness to buy have likely helped keep equities elevated in the face of unfavorable headlines)?

To give you the conclusion up front: we think that these negative factors are a headwind, with the potential to lower forward returns and cause greater volatility for risk assets. However, they are not catalysts on their own, meaning they remain poor timing tools.

This all speaks to the broader assessment of risk we have been discussing the past few weeks, so let’s start by revisiting that theme in a different way.

Henny Penny’s Inattentional Blindness

The classic fable Henny Penny, or Chicken Little, encapsulates the message about blind spots and risk we have been sharing over the last two weeks in our “Invisible Gorillas” Part 1 and Part 2 (it’s a menagerie of mixed metaphors!).

In one version of the story, Henny Penny (let’s go with this name since it is the one used in The Golden Girls retelling), is hit by an acorn. She interprets this conk as a piece of the sky falling on her head and races to warn her fowl friends, panic clucking “the sky is falling, the sky is falling.” On the way, she accepts an offer from the conniving Foxy Loxy for shelter from the falling sky, only to become lunch once trapped inside in his den.

Henny Penny clearly fell prey to inattentional blindness, or completely missing happenings around us because we are focused too much on one thing. By focusing solely on the false risk of a falling sky, Henny Penny misses the real risk of a hungry predator.

Is COVID an Acorn or a Fox?

Over the last 18 months, COVID shocks have proven to be more acorn than fox for those focused on potential virus related disruptions.

U.S. equity markets have been seemingly impervious to negative virus headlines (new variants, renewed lockdowns, surging cases and deaths, etc.), even before the emergence of virus mitigating tools, like vaccines and therapeutics, in the fall of 2020.

It has simply been the wrong trade to bet that COVID developments could derail the economic recovery, which has been bolstered by aggressive fiscal and monetary policy.

But then Friday’s Omicron selloff took hold and it revealed some interesting dynamics in this market.

An important caveat is that we cannot extrapolate from one day of trading, particularly one that had light holiday-session volume (S&P 500 volume was only 1/3 the size of the 9/17/21 rout and the peak March 2020 days) and is already being followed by a bounce in futures the next session. But there are still reactions to observe.

Amplifying Factors

Friday told us little about the potential for this virus to cause similar economic disruptions as the first COVID wave (as described above, it is still too early to tell), but instead showed how today’s market structure is poised to handle unforeseen risk.

As we described last week, factors like positioning, leverage and valuation (sentiment can be included but is also reflected by these factors) are not catalysts on their own, but instead act as amplifiers of market moves once a catalyst takes hold. It is likely that the more stretched these factors are, the greater the magnitude of the negative reaction to a catalyst.

Oil’s trading on Friday is a perfect example of this. U.S. WTI crude fell 13% on Friday. It was the largest one day drop in oil since the March/April 2020 free fall when global lockdowns were in full force.

One reason for the magnitude of this drop is that for months traders have been building up aggressive options bets for further upside in oil prices. Bets that oil would reach $100 by the end of 2021 proliferated, with some putting on even more aggressive bets for $200 oil by the end of 2022. When Friday’s Omicron news hit the tape, selling beget more selling as more and more trades had to be unwound as the oil price fell.

Oil is rebounding today, but Friday’s experience shows us that we cannot ignore these amplifying factors and should consider them in our broad gorilla/fox risk assessment.

Let’s compare where these amplifying factors stand today versus pre-COVID January 2020.

The spoiler is: more, more, more.

Positioning: More Stocks

Investors have more exposure to equities today than they did pre-pandemic.

Chart 1 shows the Federal Reserve Flow of Funds data, with equities now 38% of total financial assets, compared to 33% pre-pandemic. Today’s reading is also an all-time high.

We can also see a similar dynamic in Chart 2 with the AAII investor allocation to stocks at 70% currently today, compared to 67% pre-pandemic. Interestingly, this allocation has started to drop in recent months, maybe as a sign of investors becoming more cautious. Further, this allocation remains below the January 2000 bubble high of 77%.

Chart 3 shows how investor allocations to cash remain very low, but have ticked up slightly in recent months.

Outside of the retail/household investor, inflows into stocks have been extraordinary in 2021. EPFR data presented by BofA shows more than $1 trillion in equity inflows in 2021. That is more inflows into equities than the prior two decades combined.

Clearly, the TINA (there is no alternative) dynamic of deeply negative real interest rates have pushed investors increasingly into stocks, which raises the question: how much dry powder is there left for further increases in allocations?

Leverage: More Juice

As an expression of ebullient sentiment, investors have taken on an extraordinary amount of leverage in 2020 and 2021.

Chart 4 shows the FINRA margin loan balances skyrocketing to new all-time highs over the past two years, with margin debt now up 67% versus pre-pandemic.

We can cut this data many ways that make the picture less scary. Thanks to the huge S&P 500 rally over the past 18 months, margin debt as a percentage of the S&P 500 market cap is around 2.5% currently, which is below the ~3% level post the great financial crisis. Chart 5 shows that the amount of margin investors have compared to cash balances is not as elevated as it was during the 2018 melt-up (unfortunately the data methodology changed in 2007, so we cannot compare this to the tech bubble).

But the message remains: leverage is much higher than it was pre-pandemic, so when a shock occurs, the unwinding of this leverage can amplify downside volatility.

Also, these margin debt statistics don’t tell the whole story on leverage.

First, options use is not fully captured in this data. The use of call options to maximize upside exposure to stocks for a given principal investment has exploded to the upside. Chart 6 shows this unprecedented, 150% growth in call option volume since pre-pandemic (using 4 week moving averages).

As we saw with the oil example, when option investors are overwhelmingly positioned for more upside, a negative price shock can cause investors to have to unwind their positions, causing even more price weakness and even more selling.

Second, we also have seen evidence of an incredible amount of leverage in non-FINRA captured crypto related assets. As we have seen in many historical examples of margin calls and forced selling (When Genius Failed), weakness in one asset class can influence another asset class if investors are forced to sell a “good” asset in order to make a margin call in the leveraged asset experiencing weakness. We don’t know the extent of the overlap of equity and crypto leverage, but we will continue to watch this as a risk for each asset class.

Valuation: More Expensive

The last of our amplifiers is valuation, and the story here is clear: risk assets overall are more expensive than they were pre-pandemic.

The S&P 500 is trading with a 22.3x forward P/E ratio, that is up from 18.5x in January of 2020 (Chart 7).

Even more extreme, Chart 8 shows the Russell Growth Index is now trading with a forward P/E of 33x, compared to a pre-pandemic 22.3x (this is despite expectations that Growth/tech earnings will slow materially from elevated 2020 and 2021 levels).

Of course, there are many rationales for higher valuations: TINA (meaning with bond yields so low, equity valuations can be higher because the equity risk premium is still attractive), more central bank liquidity and improved quality of large index constituents (high growth, high margin tech companies deserve higher valuations than old economy companies that used to dominate the indices).

Similar to positioning and leverage, stretched valuations can also persist for some time, meaning they cannot be used as a timing tool.

However, very elevated valuations versus history send two important messages: there is simply less room for valuation upside compared to when valuations are depressed, and there is more room for valuation downside if a catalyst sparks an unwind.

Conclusion: Amplifiers are Important

The central message here is that positioning, leverage and valuation are all more extended and elevated today compared to prior to the pandemic in January of 2020.

Could these amplifies make this market more sensitive to future shocks/catalysts? Quite possibly, as we have witnessed multiple examples in history when an unwind is magnified by these factors (why we call them the amplifiers).

The elevated levels of these amplifiers are not reason alone to expect an end to the bull market (we need another catalyst… we’re watching you, liquidity), but they are a signal that it is prudent to lower forward return expectations and revisit aggressive risk exposures.

Until then, let’s avoid the fate of Henny Penny and try to stay out of fox dens.





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Cameron Dawson
CFA®, Chief Market Strategist