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Why Investors Can Still Stomach More Risk

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Investors are still positioned to stomach some more market risk. Investors are holding more cash than usually do historically, and they may once again be looking to take advantage of yet another market dislocation, albeit a milder one than we saw in March. 

The S&P 500 is up 41% since March 23, the bear market low. A powerful combination of monetary and fiscal stimulus, a sharp return to positive economic data and state reopenings have pushed stocks higher. 

Since June 8, many cyclicals and small caps had corrected, as virus cases prompted governors to pause reopening plans, while questions over more of the much-needed fiscal stimulus still linger. Come July, earnings are starting to roll in. The second quarter is expected to see a 45% earnings per share decline for S&P 500 companies and mark the trough of the earnings recession. This is a pivotal quarter, as the market has largely priced in the trough to the recession. 

Recently, as signs of a V-shaped economic recovery have been met with health and consumer confidence data that suggests more trouble ahead, investors have swooped up shares of big tech companies like Apple  (AAPL) , Microsoft  (MSFT)  and Amazon  (AMZN) , which have secular growth drivers that can mostly power through economic headwinds. Sure, earnings estimates have risen, but multiples had become a bit stretched as well. In the past few days, the tech-heavy Nasdaq is down a few percentage points as investors brace for earnings reports that may not justify current pice levels. 

Still, the valuation gap in cyclical value versus growth is stark. The Vanguard S&P 500 Value ETF  (VOOV) , home to many cyclicals (also defensives), is down more than 8% since June 8 and was down almost 10% from that point recently. The average stock in the fund now trades at just above 17 times next year’s earnings, slightly low given the low interest rate environment. 

That leaves an equity risk premium — the excess rate of earnings return for the next year minus the yield on the safe 10-Year Treasury bond — of about 5%, looking at fund statistics on the Vanguard website. Historically, the average stock on the S&P 500 usually trades at an implied risk premium of 3.5%. And multiples on the value ETF were lower a few days before Tuesday. That’s a long way of saying strong near-term returns could be in the cards. 

Meanwhile, the Vanguard S&P 500 Growth ETF  (VOOG)  is up 2.6% since June 8 and was up more before this week. The fund holds the large cap growth tech firms everybody loves to follow, but also stocks with some cyclical and even mature characteristics, like semiconductors and even credit card companies.

That leaves a forward earnings multiple of 28.6 for the average stock in the fund and an equity risk premium of 2.8%, not a very attractive return. That’s a long way of saying diminishing near-term returns could be in the cards. 

Enter, the cash position of vigilant investors hungry for return in a low yield world. 

After a huge increase in cash holdings during the months of selling as the coronavirus decimated economic forecasts, investors have drawn on their cash of late. That was to buy a combination of safe bonds, as yields have little chance of soaring in the near-term, and stocks, which were once selling at incredibly cheap valuations. 

Still, the average fund manager surveyed by strategists at Bank of America Global Research is holding 4.9% of his or her fund in cash, up from 4.7% a few weeks ago. And 4.7% is the 10-year trailing average. 

Institutional funds have been a bit more aggressive in the market, with cash holdings at only 4%, but up from 3.3% a few weeks ago. Retail funds like mutual funds are at 4.8%, down from 5.2%. 

“Cash says investors still cautious on virus, macro, and election,” the strategists wrote. Even so, investors are positioned to sprinkle a few more dollars into the market, especially if they see lowered price levels, a dynamic the U.S. market has seen in many pockets of time in the past few years and one that Bank of America routinely acknowledges in its commentary. 

Strategists at Morgan Stanley see investors adding more to value stocks than to growth stocks for the near future at least, both because of the valuation gap and because of the firm's particularly bullish view on the economy. 

Growth tech may need more earnings momentum, which isn’t inconceivable for the particularly strong and dominant businesses in that class of stocks. Investors already remain overweighted to tech by historical standards, Bank of America’s data show. Notable underweights are seen in banks, industrials, materials ad energy. 

All of these points support the idea that the stock market has some support to it, even in the near-term. But by the end of the year, if the consensus S&P 500 EPS estimate of around $162 holds true, the index could conceivably hit a higher mark than $3,400, even if rates rise a bit. Canaccord Genuity’s strategists have an S&P 500 price target of $3,300, representing about 4% upside from current levels. 

Threats to those price levels: a third wave of viruses, insufficient fiscal stimulus and a heavily Democratic political regime that raises corporate taxes all the way to 28% from 21%. 

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