A Corner of Chaos

Market Reaction: February 1, 2021


Financial market headlines have been dominated by the actions of a group of retail traders who have used social media to drive up the price of a handful of heavily shorted stocks. This phenomenon has caused a certain level of chaos in select corners of the market as the desires of the hedge fund community and retail investors clash.

As a result, the Chicago Board Options Exchange’s measure of market volatility (commonly referred to as the VIX) jumped to 37.2 last week - its highest level since late October. However, it’s worth noting that during the height of the COVID-led lockdowns in February 2020 the VIX soared to a level of 82.7. In our view, the recent market actions that we are seeing are much more benign and are unlikely to have long-lasting consequences for broader equity markets.

Past precedent suggests this may be fairly short-lived. In June 2020, a similar pattern played out with a bankrupt rental car company with speculators driving the stock price up over 500% in one week. The VIX jumped to around 40 on June 11th, but then steadily declined and was back to previous levels by mid-July. Most signs seem to suggest that the euphoria in these select names will also not last and that fundamentals will once again reassert themselves. Over the long-run, fundamentalbased investing has time on its side and remains our preferred method of investing.

As our Citi Private Bank colleagues point out, the 100 most shorted names in the Russell 3000 index (a benchmark of the entire U.S. stock market) make up just 0.7% of the market-capitalization. This suggests that the risk of broad market contagion likely remains low. While several market indicators suggest elevated levels of investor sentiment, which bolsters the case for a market pullback in the near-term, we remain confident that this is the beginning of a lasting global economic expansion.

As the vaccine rollout broadens, we expect a notable rebound in services activity as life gradually returns to normal and consumers shift their behavioral patterns away from goods consumption (exercise bikes, televisions, home office equipment, etc.) and towards a resumption of services (travel, leisure and hospitality, etc.) This should be supported by an unwind of the elevated U.S. personal savings rate (currently at 13.7%) and the strength of household balance sheets (household net worth is now $5.2 trillion higher than at the end of 2019).

Eventually, post-COVID booms will fade, but extremely low interest rate levels and sustained economic growth should support double-digit growth in global corporate earnings per share (EPS) in both 2021 and 2022. This should support equities in the year ahead, though it’s worth noting that valuations are stretched in certain areas after such a strong rally off the S&P 500’s market bottom on March 23rd. As an example, the top 5 stocks in the S&P 500 have averaged a return of about 250% since the start of 2018 while the other 495 stocks have averaged a return of about 130% (just under half of what the tech-heavy top 5 have returned). While news of indices hitting all-time highs may create the image of broad market euphoria, it should be noted that there are many segments of the market where that is not that case. The Financials sector is just one such example with cyclical sectors (those most sensitive to the economic cycle) expected to play “catch-up” as the economic recovery broadens.

In order to best navigate this environment, Citi Private Bank’s Global Investment Committee (GIC) has shifted its allocations within global equities and credit markets in order to lower portfolio risks modestly, reduce volatility, and potentially enhance returns. The GIC’s overweight in global equities has been reduced slightly with a decision to move from an overweight on U.S. small- and mid-capitalization stocks and North Asia’s emerging markets (including China) to a neutral position. While the GIC still views small- and mid-capitalization stocks outside of the U.S. favorably, some de-risking seems warranted in the U.S. as the Russell 2000 index has rallied an impressive 109% since March 18th, 2020. As a partial offset, the GIC added an overweight position on the global healthcare sector which has much better valuations relative to other sectors and stable growth fundamentals. The GIC also decided to switch its holdings of U.S. high yield bonds into variable rate loans as a way to potentially increase yield, lower portfolio volatility, and better position fixed income holdings for the conditions we outlined above.

A routine market pullback may be at hand, but we do not expect a deep correction in stocks