Is it getting hot in here?
After rallying to a record number of records in 2017, investors in the U.S. stock market may be fated to fall back to earth in the new year, according to one analyst, who cited the risk of managers loading up on risky names to keep pace with the broader market.
2018 markets: What to watch
"The challenge in 2018 regards the hunt to outperform," wrote Satya Pradhuman, director of research at Cirrus Research. "Our generally constructive backdrop paints a more amplified narrowing of leadership that began in 2017 and is likely to accelerate in 2018."
Pradhuman noted that a sizable portion of U.S. equity-market gains in 2017 came from just five stocks, the so-called FAANG quintet of Facebook (FB), Apple (AAPL), Amazon (AMZN), Netflix (NFLX), Google parent Alphabet (GOOGL). All those saw big gains last year, and because they're among the largest stocks around—meaning they have a higher weighting in indexes like the S&P 500 (.SPX) —they provided an outsize lift to the overall market.
The technology sector's rally in 2017 contributed nearly 20% of the overall S&P 500's 19% rise, and the sector single-handedly helped give active managers one of their strongest periods of outperformance in years. While mutual-fund managers cut their allocation to these names in the second half of the year, Cirrus analysts expect equity leadership to remain similarly narrow in 2018. That could mean a risk to stock pickers: if they go overweight on such names to compete with the overall market, they could be vulnerable in the event these highfliers see a sudden turn, something analysts have suggested is possible given their elevated valuations.
The firm referred to this as "the Icarus dilemma," in reference to the Greek mythological figure who perished after he flew too close to the sun, melting the wax that held together his makeshift wings. "Pressure will mount for managers to take on greater risks to match a top-heavy, momentum driven benchmark. In this chase for performance, investors will suffer the angst of knowing that they are traveling further out on the risk curve to simply match benchmark returns."
They're not the first to refer to Icarus. Analysts at Bank of America Merrill Lynch warned last January of the "Icarus trade," predicting stocks would soar over the first half of 2017 before suffering a second-half meltdown. The S&P 500 suffered no major pullbacks in 2017, rallying 19.4% for the year.
The concerns come at a time when investors are increasingly overweight on stocks, to a historic degree by some measures.
Focus on investing
The latest AAII investor sentiment survey indicates that 52.6% of polled investors are bullish on the market, meaning they expect prices will be higher in six months. That's the highest level in more than three years, and significantly above the 38.5% historical average. The number of bullish investors has gone up by 2.1 percentage points in the last week alone, while the percentage of bearish investors has dropped to a two-year low of 20.6%, down 5 percentage points over the last week.
Separately, cash balances for Charles Schwab clients reached their lowest level on record in the third quarter, according to Morgan Stanley, which wrote that retail investors "can't stay away." Also in the third quarter, households and nonprofits held 36.3% of their money in stocks, the second-highest rate ever. The only time this peak was topped occurred in the first quarter of 2000, during the peak of the dot-com bubble, when stockholdings reached 42% of total assets.
Morgan Stanley noted a similar trend in institutional investors, who it wrote were "loading the boat on risk," with "long/short net and gross leverage as high as we have ever seen it."
Margin debt, which is viewed as a measure of speculation, was at elevated levels all throughout 2017. According to the most recent data from NYSE, it hit $580.95 billion at the end of November, its fifth record in a row, and up 3.5% from October. Records aren't rare—according to data from Bespoke Investment Group, more than 23% of all monthly readings are records—but the 11 highest readings on record all occurred in 2017.
These trends have amassed alongside a market that is by some measures the most expensive in the world. David Joy, chief market strategist at Ameriprise Financial, noted that "the current P/E ratio of the S&P 500 is 30 percent above its 10-year average, and 20 percent above its five-year average."
He added, "That may be justified in light of prevailing interest rates, but rates are expected to rise further."
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