Feeling the Fear of Missing Out?

Recent market behavior suggests that investors may be motivated to buy U.S. stocks by little more than a fear of missing out. But chasing market momentum rarely works as a long-term investment strategy, which needs to balance market dynamics with corporate profits, stock valuations and economic growth. When these fundamental factors are out of whack with stock market performance—as they are now—it’s a cause for concern.

I’ve been writing a lot lately about reasons for caution. Stock valuations are historically high, relative to corporate earnings, which aren’t growing. Interest rates are very low, despite the potential for rising inflation, which could trigger a jump in Treasury yields that may also reduce stock valuations.

Meanwhile, measures of investor sentiment—such as hedge funds allocating more assets to stocks, individual investors reducing their cash positions and rising bullish expectations—all point to investor euphoria, which is a contrarian indicator.

Here’s my latest observation: Due to the surprising set of correlating asset classes—U.S. stocks, gold and U.S. Treasury prices are all near multiyear highs—diversification may not work as expected in the next downturn. The best example may be how stock and bond prices are rising in synchronicity, something that has been going on for much of the current business cycle due to Federal Reserve interest rate cuts. Lately, this parity in gains between stock and bond prices has converged even more, despite no new Fed guidance to indicate further rate cuts this year.

Bond yields, which move inversely with prices, have been falling, as investors price in more rate cuts, perhaps anticipating a global growth slowdown due to the coronavirus outbreak. If global reflation picks up, as we expect, Treasury yields would likely rise, and we could see stocks and bonds both decline in price, even as the economy improves.

Another example: Gold has recently reached a seven-year high, correlating with a stronger dollar, which is approaching six-month highs against other major global currencies. Both gold and the dollar are typically inversely correlated, since dollar-denominated gold should get less valuable as the dollar strengthens.

Again, the coronavirus outbreak may be contributing to fear about global growth that is attracting investors to both gold and the dollar, but I think that analysis may be too simplistic. To me, the correlation between gold and the dollar suggests markets may not be pricing interest rates or inflation correctly.

The way I see it, investors’ fear of missing out on U.S. market momentum may be combining with excessive global liquidity from central-bank easing to create distortions in traditional asset class correlations, which is why diversifying across asset classes may not be enough to protect investors in the next downturn.

Instead, consider diversifying within asset classes. For example, among U.S. stocks, I suggest investors shrug off any fear of missing out on additional gains in the secular growth names that dominate the S&P 500 and redeploy assets into underpriced cyclical sectors, such as financials, industrials, energy and commodities.