As we exit Q2 and move into Q3 of a mind-numbing year of volatility, now is a good time to review the thesis surrounding our bullish stance coming into Q2 and moving forward through Q3.
In my note from March 29th titled “It's Time For Investors To Go All In On Equities,” I asked investors to adopt the following mental framework in order to properly align with what was actually occurring in the markets:
1. This is not a bear market
2. Poor economic performance over the next few months doesn't necessarily equate to poor stock market performance
3. Far from being irrelevant and out of ammunition, the Fed is more relevant than ever
4. There is no historical reference to this market. It is completely unique and unprecedented in scope. Future results will reflect this fact.
At the time, the reason it was important to adopt this framework was so that investors would not be led astray by data points that were largely irrelevant and in fact, harmful to creating alpha moving forward.
Understanding that we were not in a bear market was key to properly constructing a beneficial technical framework for the market moving forward.
Understanding that poor economic data moving forward was largely irrelevant was key to remaining bullish through the turbulence that would be created through lagging economic data.
Understanding the Fed would move the markets significantly through expanding their balance sheet was key to determining that overall risk/reward in the markets was in its best position since the 2009 lows.
Understanding that there was no historical reference to this market was key to staying put in leveraged long positions without getting thrown off the scent of the market with irrelevant comparisons to past technical or fundamental indicators.
Now that we have experienced a historic rally in the markets during Q2, with all of the aforementioned foundations for a properly aligned mental framework proving beneficial, the question becomes does this framework continue to apply and if not, what mental framework can we adopt to maximize gains during Q3?
The most basic fact that is commonly misunderstood by investors, leading to all types of errors in analysis, is classification of the market during any tumultuous period as a bear market. The virus correction during Q1 was just that...a correction within a secular bull market. Coming into 2020, I said that the markets would experience a decline that would be viewed as catastrophic. The reason for that view is a very a simple understanding of how bull markets function as they mature.
Within every secular bull market, the investor psychology within the bull market is identical. Investors begin a bull market in a state of sheer anxiety. As the bull market progresses they begin warming up to the fact that their anxiety may have been unwarranted. Then they slowly begin investing capital, with glimpses of fear along the way. Leading to the final stage, where they indiscriminately throw capital into equities because stocks will never go down again and the economy is doing so great.
As participation in a bull market increases, the market needs to take greater steps to reset expectations during any correction phase. This is due to the fact that as investors become more comfortable in their investments, it takes greater downside force to create the fear necessary to properly reset risk and effectively rinse investors so that the market can continue forward in an expeditious manner, in the hands of investors who are surefooted and sticky in their commitment to the bull.
What we saw during Q1 of 2020 was one of the most significant risk resets within a secular bull market that can be experienced. To find the nearest comparison you would have to go back to late 1998, with the LTCM disaster and the resulting Fed actions to avert a financial market crisis, leading to a historic run for the markets through 1999 and into the 2000 bubble top.
With this level of risk reset that we have recently experienced there is no going back. Especially when the market successfully left behind as many investors as it did, forcing them to miss out on the historic gains of the past quarter.
And now what do we have? We have the curtain being pulled back, revealing that the economy really isn't as bad as everyone expected. In fact, the economy is doing significantly better than forecast. The companies that have been reporting thus far have been blowing away estimates by a significant margin, most notably last week with Fedex and Micron. Two completely different parts of the economy that show significant strength moving forward.
This leaves those investors who were rinsed out of the market during Q1 feeling manipulated, regretful and bitter. Those feelings naturally turn into bearish sentiment, along with a hesitancy to reallocate their capital for fear of getting burned again since the market seems to be so high in the clouds after being launched off the March lows. To reinvest at these heights, looking down from 5,000 feet up in the air, knowing that the ground is so far away if you fall is a frightening proposition.....by design.
To put it simply, the market has done a masterful job of moving up significantly without much weight on its shoulders. Exactly how it likes to move when its moving in its most efficient and profitable manner.
As the economic picture continues to improve, with continued monetary and fiscal stimulus driving the economy, the only thing that the vast contingent of bearish investors have to rely upon is the virus. This is more than likely why virus news is causing so little in the way of turbulence in the markets, apart from 1-2 day affairs that are quickly picked up by those who are underexposed to equities.
In fact, it's not unreasonable to state that the virus, while being a great tragedy for not just many individuals, but society at large, creates the perfect backdrop for bullish momentum on the upside that will continue to be historic in nature. What the virus does for the markets is twofold:
- The virus creates a wall of worry that is cemented by the March crash creating a form of post traumatic stress in investors, with every slight drop in the market reminding them of the terror of the March decline.
- The virus creates extraordinary demands on both monetary and fiscal authorities to support the economy and thus the markets.
Two perfectly aligned factors that can lead to the most bullish outcome possible for the financial markets moving forward.
The foundational mental framework during Q3 is as follows:
1. We are in a secular bull market that experienced its greatest risk reset yet during Q1.
2. The market has successfully rinsed a significant number of investors. Those same investors will not be allowed back into the market unless they chase higher. In other words, the market will not come to them, they have to come to the market.
3. Economic and earnings reports will continue to surprise on the upside, creating a virtuous cycle of increasing equity prices and greater investor participation, as positive data will dictate bullish action.
Much like Q2, Q3 will be a largely positive quarter with the only difference being increased volatility during multi-day corrections to come.
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