August is usually a dull month for the markets because the B-team is typically staffing the trading desks. Wall Street takes the month off and heads to the Hamptons, or is busy getting kids back in school. This year, everyone has already left NYC because no one has been at work since March. Because the schools are closed, there is no reason to take off a couple of weeks because kids have been on vacation essentially since March as well, not to mention there is nowhere to go. Couple that with the Robinhood traders buying call options on tech stocks, and you get the best performance for markets in the month of August since 1986. So what are markets going to do from here? Is this all-time high market level, which was unthinkable back in March, ready to reverse lower? Let's look at a few indicators and then examine what might influence the direction of this market as we approach the final quarter of the year.
With stock splits suddenly back in vogue and adding hundreds of billions of dollars to valuations of companies, the market is displaying bubble characteristics, especially in the tech sector. A sentiment data point I monitor is the National Association of Active Investment Managers (NAAIM) Average Exposure Index, which shows the average exposure to US Equity markets reported by members.
As illustrated above, we are back to levels not seen since 2017. This indicator, however, tends to be a better indicator at market bottoms than tops - so the fact that every investment manager is leaning with more equity exposure than normal, isn't a great predictor of a market top.
Looking at the Nasdaq, and stocks like Apple and Tesla, it feels a lot like the 2000 bubble when tech stocks seemed to only go up. Options for stocks and indexes used to be only available with expiration dates that occurred on the third Friday of the month. "Weekly" options that expired every Friday started trading on broad market indexes, and became so popular that you can now trade S&P options on Monday, Wednesday and Friday. Single stock options on some of the more popular stocks, like Amazon, Apple, Netflix, and of course every Robinhood investor favorite, Tesla, are now available at the weekly level as well with option expiration dates every Friday. The result is you can super leverage a Robinhood or TD Ameritrade account by simply clicking an options agreement signature button a few times. Suddenly you can buy a derivative that gives you the ability to buy high-flying momentum stocks with super leverage. For example, for a mere $1,000, you can buy the option to own $3,000,000 worth of Tesla stock at a much higher level than it is currently trading that expires in a few days. It might seem like a real lottery ticket, and likely that $1,000 will turn to zero. But when the stock is going up 10% a day, that $1,000 worth of an option can suddenly have a value of $30,000 not only in a few days, but in a few hours as the option sellers scramble to cover their short position leading to a feedback loop.
The chart below illustrates option growth specifically for call options, which give you the right to buy a stock at a specific level. More importantly, this is being concentrated in just a few names. Call options buying versus put options is at all time highs as illustrated by the blue line.
What about large allocators or hedge funds? Are they participating in this rally? The chart below tracks "smart money" equity exposure. Hedge funds usually have relatively lower net market exposure as they tend to try to profit off their stock picking skills as opposed to trying to pick market direction. In a 10 year bull market, that strategy tends to underperform owning a portfolio with a net 100% long strategy. Despite the recent market rally, hedge funds still are positioned with some of the lowest net exposure the market has seen since 2009 (stocks were cheap then, and the fundamentals didn't look so good either - but a great time to buy stocks). Fundamentals obviously are weak, but this low exposure might actually be a contrarian indicator. Note that hedge funds had much higher exposures in the 3rd quarter of 2018, right before the market tanked.
Sentiment indicators actually point to a market that could continue to rally. As in 2000, stock prices can decouple from valuation levels significantly in markets that are attracting speculative traders. With mobile trading platforms, easy access to leverage, and social media tools such as YouTube, Instagram, and Twitter, the environment is conducive to limited information from the most easily digestible research. Social media's format, which is designed for information consumption in as little as 280 characters, can't possibly provide the type of information that is required to accurately value a stock. Instead, a quick hit story on tapping into a pig's brain seems perfect for a stock pump.
Where the markets go from here depend on two critical components, election developments and the progression of COVID-19. Trump's odds have naturally improved following the Republican convention, which seemed a bit more normal than the Democratic convention, where virtual constituents made the event feel like it was out of some space aged-theme movie, where attendees were joining in from somewhere in space. Trump's betting odds were more than 25 points behind Biden, but as violence from protests escalated toward the end of the month, the shift in polls began to favor Trump. While the media outlets likely have a bias toward portraying protests as peaceful, social media now plays an important transmission role in the news cycle. Voters can easily discern whether protests are violent or not. The distribution of videos of looting in Chicago, L.A. and NYC, or private citizens homes being targeted because they are in a specific gentrified neighborhood could have a significant impact on the 2020 elections - as they did in the 1968 elections that helped elect a Republican president. Unless Democrats pivot from their current stance regarding demonstrations and defunding the police in reaction to the polls, which would then alienate the left wing of the party, Trump momentum could continue into November.
Finally, daily U.S. COVID-19 cases continue to drop, and there are no geographic areas that are still susceptible to a large surge now that California has been essentially infected. New COVID-19 cases are declining at a rate of 20,000 cases/day per month implies that the pandemic is on course to significantly subside in time for the election. We continue to believe we have seen the peak in US daily cases and deaths, and that economic reopening stocks values are priced too low and are offering an opportunity as the media downplays the improving conditions. We have begun adding to the travel and hospitality sector, and feel stocks like Disney and Starbucks offer upside here.
