Are We Back to a 'Risk-On' Market?

Stocks have been grinding higher even as interest rates and oil prices have come along for the ride. The question becomes – is now the time to position your portfolio for another leg higher or is it time to cash in some profits?

When we say it is a “Risk-On” market, it implies that the market will continue to run and short positions will be squeezed higher. And it means we are bullish. There are several reasons to be bullish now, but there are nearly as many reasons to be bearish as well.

To that end, let’s dive into both the bullish and bearish sides of the argument, then examine how to implement the best strategy.

We’ll talk about the bull case first.

The Bull Run Thesis

The thing the bulls will point to most is that everyone is calling for a recession, but it is nowhere in sight. The July jobs number showed an increase of 187K jobs and unemployment moved down from 3.6% to 3.5%. Those aren’t numbers indicative of a recession.

The Fed has pushed rates to 20-year highs in a short period of time to help control inflation, but that has not stopped investment and innovation. New technological developments and shifts in the geopolitical spectrum are certainly tailwinds for the bulls.

There was also a ton of talk of an “earnings recession” that would see corporate profits continuously slip away. That argument is nearly dead on the vine as second quarter reports were on the whole, stronger than expected.

The Bear Thesis

A deeper look into the last two jobs reports suggests that the gains are low quality with the government accounting for a large percentage of new hires. The JOLT job openings number is also starting to shrink from historic highs. So while the headline numbers are ok, the weakness is below the surface.

Higher rates are generally not a good thing for equities as it provides investors with an option of safety and a more competitive return. There has been a flow of cash into money market funds over the last few months, and some of that has come from equity markets. Those higher rates will be a persistent deterrent from money moving into the markets.

The new technologies are a source of hope, but the bears will tell you that some are years, if not decades, away from being significant drivers for the market. Some of the most bearish market participants will say these new developments bring about bubbles that are routinely popped over time.

Earnings season has been better than expected, but the key word is expected. With so many calls for recession, there has been a latent and persistent overhang that has held expectations at bay. Companies have been able to pass along price increases, but that will not last forever.

Internal Dynamics

Outside of these bull and bear arguments for the market direction, it should be pointed out that we are coming off of some historic moves in the market. Not directional moves, but instances of huge hedging, and it may portend a dramatic move in equity prices.

Over the months of June and July, there was significantly more options activity. June saw a record number of options only to be surpassed by that volume in July.

Hedge funds have shifted strategies from being short massive amounts of stock to relying on options. The reddit crowd and other funds have been targeting stocks with large short positions that have forced the shorts to cover. This is not a new phenomenon, but it has been happening with much greater frequency.

The results of this action have stunning implications. A tier one brokerage recently noted that we are now at record lows in terms of stocks that are shorted. Also in that report, the firm noted that long exposure was at record highs.

The scary implication is that should markets see a significant drop, there will not be short covering to lessen the blow. Instead, we could see a higher level of volatility to the downside in a “black swan” style event.

If nothing else, this should remind investors to be cautious when chasing stocks that have seen significant moves in either direction.

Geopolitical Events

I like to say the fuel that the world’s economy runs on is oil. If the price of oil is dropping month after month, then an economic slowdown is usually afoot. When prices are moving steadily higher, we can also extrapolate the idea that the economy is improving.

What is left out of that general idea is that oil is a commodity based on supply and demand.  When there is a lot of demand and supply is held constant, then prices will increase and vice versa.

The war in Ukraine has impacted demand energy in a number of ways. Not only have the warring nations and their supports increased demand for oil, but there has also been an abrupt halt to the supply of natural gas to European nations from Russia.

The market supply for oil is also seeing some constraints as domestic oil production has slowed over the last several months and OPEC has moved to limit production in an effort to keep prices high. Saudi Arabia has even committed to an extra 1M barrels per day cut.

New Technological Developments

Artificial Intelligence (AI) has been the talk of the town for the last several months. It was less than a year ago that ChatGPT really came on the scene and it looked like pure magic.

Asking ChatGPT to write an article for the first time was great and we could all see that.  Having it write computer code for you is taking it to the next level. However, there are a lot of people who have found flaws with the service.

There were widely published instances of AI providing false information, most notably when a lawyer filed a brief that cited cases that did not exist. The owner of the AI can influence the outcome as the Yandex AI tool Alice was pro Stalin, supported wife beating, child abuse and suicide.

Super Early Innings of a Breakthrough New Technological Development

There is a new development that has monumental potential for all of mankind. That is a pretty big statement to make, but it is true. A breakthrough in the Superconductor space has come from Asia, but has quickly been replicated several times, including once at Berkley.

The early information on what is really going on might require a degree in physics to totally understand, but investors are already moving on several stocks in the space.

The ramifications of a superconductor working at or near room temperature changes the game for heavy users of electricity. It could also have major implications for the transportation industry down the road.

This is the definition of a nascent industry – not fully understood and very early. Make no mistake, there are plenty of companies that already trade publicly in this space, but it could take a large amount of time before the solutions make a meaningful financial impact.

Stay On Top Of The Market

When making a decision about whether or not this is a “risk-on” market, investors have to be cognizant of both the bull and bear theses. In addition, there are many other factors that investors should consider when looking to be more aggressive. Interest rates should be near the top of that list in terms of deciding how aggressive you want to be at this point.

Watching the market daily is very important. Information is moving faster than ever and staying abreast of the developments taking place is getting  harder and harder. We used to be able to follow the actions of single companies, but today we need so much more emphasis placed on the macro environment as those changes can really push the equity market around.

Achieving Higher Returns

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Zacks Investment Research

This article originally appeared on Zacks

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