The overall performance of the stock market in the previous few months has fuelled sentiments among investors, some even thinking that it is in a bubble. To try to diffuse the storm surrounding the trading environment, investment bank and financial services holding company JPMorgan hosted a virtual meeting in which its top strategists went over the most important trends driving the stock market in 2021.
We put down a few notes for you.
The stock market is a little frothy around the edges, but it is not a bubble
First off, it is okay to fear that the stock market is in or heading towards a bubble for obvious reasons given its recent performance. The good news is that JPMorgan strategists do not think it is in a bubble. In fact, they think it is quite the opposite. They are convinced the ongoing stock rally is just in the first innings, and that it will rage on well into next year.
However, they warn of bubbly pockets especially in sectors favoured by individual investors. The good news is that the frothy part of the market is relatively small. And if there is a drop in some sectors, it will most likely not drag down the rest of the market.
“We do see some relatively contained market segments that appear to be in a bubble related to Electric Vehicles (EV), renewable energy and innovations stocks. These sectors only make up a small part of the market (e.g., electric vehicles make up only 2% of the S&P 500),” JPMorgan strategists said.
On the other side, JPMorgan strategists see a whole range of sectors that are still cheap based on their valuation models, including energy. Earlier this year, they called the energy market a “stock picker paradise.”
So, if the stock market is not in bubble, what is it?
JPMorgan says it is a bubble of fear. What JPMorgan strategists see as a bubble, most investors do not even think of as an asset class. It is funds that track the VIX—an index weighing investors’ expectations of volatility in stocks (aka a “fear gauge”).
The VIX index is derived from the prices of options; a tip-off to where investors are betting stocks prices will be in the future. The VIX shows that lately, investors have been more fearful than they needed to be.
“The VIX is now disconnected to underlying short-term S&P 500 realized volatility, indicating a bubble of fear and demand from investors looking to hedge or profit from a hypothetical market selloff.”
JPMorgan calculations show that VIX is 400-500% above the “fair value.” This means that investors are massively overpaying for options to protect their portfolios from a potential downturn in stocks. This is what the strategists call a “bubble of fear.”
Investors are preparing for reflation
JPMorgan noted that institutional investors are preparing for the return of inflation and higher interest rates as the economy further reopens. They are reducing their tech stocks (because the sector is more sensitive to higher rates) and picking up more stocks that have been beaten down most during COVID-19.
According to JPMorgan, institutional investors currently have a strong interest in reopening names such as transports, casinos, as well as leisure and hospitality stocks like cruise lines and hotels. This is accompanied by a growing interest in financials and energy.
This, JPMorgan analysts believe, is one of the reasons the stock market has been a little choppy lately.
Bitcoin deserves to be in your portfolio even if it is driven by frenzy
The last two months or so have seen the world’s number one cryptocurrency Bitcoin surge, breaking all-time highs and setting new ones. The digital currency even surpassed the $50,000 mark on February 16.
Since September last year, Bitcoin has drawn an impressive $700 billion and it is rumoured that institutional investors are behind this massive gain. However, But JPMorgan data shows only $11 billion of Bitcoin inflows came from institutional investors, including the $1.5 billion automaker Tesla bought a few weeks ago.
This shows that individual investors still mainly drive Bitcoin so JPMorgan advises against using the cryptocurrency as a hedge against a downturn in stocks that have been bid up by individual investors.
“The mainstreaming of Bitcoin is raising its correlation with equities. Since holders of Bitcoin and single name stocks have the same risk preference around macro shocks such as in interest rates, there is a risk of simultaneous deleveraging in both of these assets.”
However, the firm’s strategists think cryptocurrencies deserve a place in the portfolio, suggesting that investors can likely add up to 1% of their allocation to cryptocurrencies in order to achieve any efficiency gain in the overall risk-adjusted returns of the portfolio.