With U.S. stock prices exceeding pre-coronavirus highs and credit spreads nearly as tight as before the pandemic, investors are signalling overconfidence in the market, says Rob Almeida, portfolio manager and global investment strategist at MFS Investment Management.
While polls and betting odds appear to be favouring a Joe Biden win, that doesn’t align with what Almeida is observing in the market. For instance, U.S. small capitalization stocks are showing strength relative to large cap stocks, which may signal an edge for a President Donald Trump win. “The magnitude of outperformance of small cap stocks, to me, signals something different than what the polls imply if we assume that [corporate] tax rates will be higher . . . and there will be a fairly strong step function change in minimum wage. Both of those are disproportionately more negatively impactful to small cap companies.”
Further, implied volatility is high. Forward volatility generally moves inversely with asset prices and signals what level of premium investors are paying for protection. “I think that is a function of the market expressing confidence on one hand, just given the level of asset prices, and then on the other hand, it’s expressing some uncertainty or expectations of pretty significant volatility,” says Almeida.
Highlighting how different types of investors can tell different stories, he notes that retail buyers could be pushing asset prices higher, whereas institutional investors, like pension plans, may be buying protection and expecting more volatility. “So a lot of mixed signals at the end of the day.”
Overall, profit margins were falling before the coronavirus crisis, costs and debt levels are now higher for most companies around the world and revenue is nowhere near 2019 levels. “All of those things, I think, compute to what will be a margin profile that won’t look like 2019’s margin profile. But the market is discounting that it will — or actually it will even be a little bit better.”
At the end of the day, it comes down to the sustainability of a company’s cash flows. “And assets that lack that sustainability and surprise the market with something that is less than what they expected, I think that’s going to be a painful experience, particularly given where valuations are.”
Ultimately, investing is trading cash flows today in exchange for the hope of future cash flows, he says. “Whatever happens on Nov. 3 — or I guess when the dust finally settles — I think markets will then re-assert their attention, I would believe, to what’s material because, ultimately, at the end of the day, it’s all investors care about. What will the return on my investment be? And I think expectations are a bit too high.”