We have previously discussed the near “mania” of retail investors taking on exceptional risk in various manners. From increasing leverage, engaging in speculative options trading, and taking out personal loans to invest, it’s all evidence of overconfident investors.

However, that “risk appetite” is not relegated to retail investors alone. Professional managers, institutions, and hedge funds are “all in” as well.

Money Flows Are Huge

The evidence of “professional investor” exuberance is the massive inflows of capital. The first half of 2021 outpaced every year since the Financial Crisis lows.

Hedge Funds Are All In

Hedge fund managers are now extremely long “risk” exposure.

As stated, that “career risk” has professional managers chasing performance after suffering a rough start to the year. The need to make up lost ground, or risk losing assets to better-performing managers, rises with the market. Per the Wall Street Journal:

“Client notes from both Morgan Stanley and Goldman Sachs show fundamental stock-picking manager had negative alpha in the first half of the year.

Part of the challenge for professional stock pickers is that markets are heavily rotational. Markets this year whipped back and forth between growth and value stocks. Such makes it difficult for managers to find winning trades.”

“The latest estimate of Hedge Fund Exposure shows that funds are nearly 40% net long stocks, a quick rise from almost being flat a month ago. Over the past few years, after such large allocation increases, the S&P gave any further gains back.”

“After any day since 2003 when Exposure was below zero, the S&P 500 returned an annualized 15.2%, versus only 1.4% when Exposure was above 25% as it is now. If we look at the period after the first reading above 35% the medium-term returns were unimpressive.“ – Sentiment Trader

The point is that when professionals investors get “sucked” into performance chasing, it warrants being more “risk” aware.

As Bob Farrell once quipped:

“Investors tend to buy the most at the top, and the least at the bottom.”

Smart Vs Dumb Money

None of this should be of any surprise. After more than a decade of monetary interventions, the psychology of QE is now thoroughly ingrained. The problem eventually is that with investors very “long” the market, there will be few “buyers” when it comes time to sell.

“10-year forward returns are below zero historically when the price-to-sales ratio is at 2x. There has never been a previous period with the ratio climbing to near 3x.”

However, in the short term, investors are trapped by the “fear of missing out.” While there is plenty of logic for sitting out of an overvalued, exuberant and stretched market, there is a consequence to “missing out.” While a bear market does indeed destroy capital, not participating in a bull market has an equal impact on ending results. 

It’s a terrible choice.

Conclusion

A correction is coming. I have no idea when or what will cause it.

However, the markets are currently in a very long advance without a 5% correction or more. So when it occurs, for whatever reason, it will “feel” worse than it is. That is due to the high level of complacency investors have developed in this market.

While we are only expecting a correction in the near term, you cannot dismiss a “real bear market” either.

It may not be today, next month, or even next year. But there is one truth in a market with all the signs of exuberance.

“Bull markets are built on optimism and die on exuberance.”

All bull markets die eventually. We never know the cause in advance. Ignoring history won’t make the damage any less catastrophic.

Historically, we find that when both valuations and prices have extended well beyond their intrinsic long-term trendlines, subsequent reversions BEYOND those trend lines have ensued.

Every Single Time.