The case for stocks to carry higher through the end of the year is uncomplicated: It’s a bull market, most years finish strong, Covid vaccines are coming, the recent run-up has been broad and well-led by riskier stocks, profit expectations have turned up and the credit markets are in a giving mood.
The obvious thing working against this upbeat set-up are the burden of record Covid-case growth and the economic drag of health-related suppression measures.
These offsetting forces have held the S&P 500 in a narrow and tightly coiling range in the past two weeks, unable to use good vaccine news to push to new records but so far without much net damage done to the broader up trend.
Yet there are less-apparent hurdles the bulls will have to clear over the next several weeks related to the broader supply and demand for stocks.
Pension Fund Profit-Taking
One headwind is a result of the market’s very strength to this point. The sharp outperformance of stocks versus bonds this month places pension funds and other asset allocators in a position to be fairly heavy sellers of equities into the end of this month or December.
Wall Street firms have varying estimates on the magnitude of pension rebalancing, but some are running toward $50 billion in net outflow from equities, on the high end of historical readings.
JP Morgan last week estimated some $160 billion globally in net selling potential in stocks into year end from balanced mutual funds, which maintain a fixed stock-bond mix.
While this activity can be absorbed in a $95 trillion global stock market, $30 trillion of which is in U.S. stocks, it can send a flutter through the tape nonetheless.
Tesla’s Index Entry
In a similar vein, Standard & Poor’s decision to add Tesla to the S&P 500 next month will force some mechanical selling by index funds of the other 499 stocks in the benchmark. S&P has said it is soliciting ideas on how to transition Tesla into the index in the least disruptive way, perhaps by doing it in two stages.
Several stocks are added to the S&P 500 every year but Tesla will be by far the largest ever to be admitted. Its market value is $464 billion, though its weight in the index will be based on the 80% of market cap represented by the freely traded shares (founder and CEO Elon Musk owns about 20%). With index funds owning about 15-20% of the S&P 500, it would mean $55-$75 billion worth of the other index stocks would have to be trimmed and the cash reallocated into Tesla.
This can be made a smoother process through index-fund managers’ sophisticated execution systems, but it would mean a drag.
Berkshire Hathaway was the last comparably big new index member in early 2010. Its market cap was just under $200 billion, in an S&P 500 whose total value was about one-third as large. The market was choppy in the weeks around Berkshire’s entry but not notably because of it.
In less technical ways, Tesla’s induction into the S&P resembles the 1999 entry by Yahoo – similarly a high-flying stock that embodied the technological excitement of the era, which had only just turned profitable. Its entry into the S&P in December 1999 was close to the stock’s ultimate peak and preceded the broad market top by three months and about 10%.
That’s not a prediction, just some context.
New Stock Supply
A market that’s receptive to new equity issues is a healthy one, keeping capital flowing into businesses and bolstering corporate balance sheets. Yet too much at once can cause investor indigestion.
The volume of equity offerings has been blistering this year, with both IPOs by upstarts and follow-on offerings from often cash-strapped pandemic-impaired companies flying onto the exchanges.
As shown here, halfway through the fourth quarter, total equity issuance is running far ahead of prior fourth quarters, according to Dealogic.
Some $60 billion of the total has been raised by SPACs, or special purpose acquisition companies, which simply collect cash from investors to buy a private company. The forward calendar for deals is pretty full, and sizable IPOs are poised to debut from Airbnb, Roblox and several more newcomers.
Again, this rush to sell stock is a feature of a bull market, and only a concern at extremes or times of market stress. If nothing else, a test of investors’ appetite for adding risk in the year’s home stretch.
Investors’ Aggressive Stance
On the demand side, retail investors have already generated the largest two-week flow of cash into equity funds ever, according to Bank of America, at more than $70 billion.
Hedge funds and other tactical professionals, too, are pretty close to being “all in.” The Evercore ISI survey of hedge fund managers last week showed their net exposure to equities near a three-year high.
The latest National Association of Active Investment Managers’ weekly poll similarly showed average equity-commitment levels matching their 2020 high from late August, days before the S&P 500 peaked and entered a swift correction.
Cantor Fitzgerald strategist Eric Johnston last week turned “tactically bearish” on stocks, expecting a pullback before the market heads to further highs in coming months, based largely on positioning and sentiment gauges. Among them, total short interest on the New York Stock Exchange hitting a six-year low.
Extended positioning and the overhang of fresh equity supply could help explain the market’s inability to capitalize on the upbeat vaccine-trial news the past two Mondays, and its modest 2% slippage from a record high.
There is no damning indictment here of the bull case, which enjoys an upward historical bias over Thanksgiving week and beyond. The supply-demand factors laid out here are simply potential pressure points in a market already working to digest a strong run that has it still up almost 9% this month.
If the pressure is absorbed without much trouble, it would be another test passed by a bull market whose strength surprised most investors for months, before the majority more recently turned into avid believers.