04 March 2025
Differences of opinion between market participants are often (not always) a matter of time horizon. From our perch, sentiment on a shorter time horizon, has become rather pessimistic on some key measures. For example, the AAII US investor survey increased to 60% bears last week. For perspective, that is comparable to the 2022, 2020 and 2008 episodes (chart 1). Of course, the drawdown from peak in the current episode is less than 5% from peak compared to -25%, -33% and -48% respectively in the other examples. Moreover, most other measures of sentiment and risk compensation remain extremely benign by historical standards. (chart 1).
Chart 1
From a tactical perspective, our sense is that sentiment (as of Thursday last week) had become too pessimistic in the short term. As noted above, investor surveys such as the AAII, increase in demand for put options (protection) and CBOE Skew suggested that the S&P500 (the global risk proxy) might have completed most of the probable drawdown in the near term (chart 2). To be fair, the correction in key mega-cap technology stocks or the leaders of the bull market has been much larger. The drawdown in the NASDAQ and NVDIA was almost 10% and 20% respectively from peak. We would also note that US equities have been in a sideways (“consolidation”) range since November. Albeit there has been considerable rotation within the S&P500 and between US and international markets. The world’s most hated markets: Europe and China have materially outperformed US equities year to date. It has been the ultimate pain trade.
Chart 2
On a longer time horizon, most measures of US sentiment and risk remain extremely complacent. The price to earnings valuation of the S&P500 is well above long term average and the equity risk premium is extremely narrow relative to history. In the credit markets, the high yield bond spread is one standard deviation below history. Implied currency volatility is also around half a standard deviation below average or extremely complacent compared to 2022, 2020 or 2008 (chart 3).
Chart 3
As we often note, there is an intimate link between liquidity, leverage, and volatility. Put another way, long phases of low rates and policy support (forward guidance, QE, and fiscal easing post 2020) contributed to an increase in leverage. Treasury Secretary Scott Bessent articulated this clearly: “We’re seeing the hangover from the excess spending in the Biden years. In 6 to 12 months, it becomes Trump’s economy.”
The hangover analogy is a good one. Policy easing to offset the hangover forever and ever with the “hair of the dog” (more easing) becomes a self-reinforcing or reflexive feedback loop. Bessent has recognised that the disease is the drinking (excess policy easing) not the hangover. To address the disease, the US Administration requires the reverse feedback loop. Of course, if the fiscal tightening is large enough the cycle might end in recession. Or as Dave Dredge would say, “the good outcome (for debt sustainability and Treasuries) is a recession.”
The implication for investors is that major phases of volatility have followed long periods of stability. Business cycles tend to be non-linear, not gentle, or smooth. If the US Administration achieves a reduction in the fiscal deficit to 3% over the next few years, that would be a meaningful reduction in the fiscal impulse or government contribution to growth and liquidity. In that context, the cost of protection, especially in credit, remains inexpensive for the potential payoff. Tactically, markets have priced a lot of the market unfriendly policies (tariffs and the breakdown of geopolitical alliances) as we warned at the start of the year. In the near term, there might be some relief if Treasury yields and the US ease. In the medium term, implied volatility and risk compensation remain too low.
Comments