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  • Mohammad Naqvi

Financial Markets - Disconnected from reality?


Every now and then one comes across a situation that baffles the investing intellect as markets behave in irrational ways. However, as time goes on one of two things happens. Either the market comes back in sync with reality e.g. the continued rise in stocks in the late 1990s led to a sharp decline in the tech sector over the next several years, or we come to realize that the market was discounting the right events which were hidden in the noise of media and social platforms e.g. the sharp and sustained rally from March 2009 or 2016 lows which was doubted by many for many months but later was supported by an improving economy.


As a principle, markets are always right because it is not our assessment that results in profits. It is rather our alignment with the price that yields returns. Therefore, it is paramount to ensure that one's own assessment doesn't cloud their judgment in portfolio construction. Otherwise, this could result in a negative cycle of performance. At Penta Capital, we try to be as objective in our investing approach and use economic assessment to understand the narrative that might be driving the action.


The goal of this article is to discuss four reasons where there appears to be a substantial disconnect between economic reality especially with the recent sharp rally to new highs and our approach:


Reasons for Concern:

  1. A sharp increase in the number of COVID cases and deaths in the US and Europe

  2. Start of a targetted lockdowns around the world with a potential for these to be much more widespread, which will impact the economic activity

  3. An outgoing administration in the US (still has ~67 days left) unwilling to lead during this pandemic while it wrestles the election results.

  4. A divided congress that failed to pass a stimulus before the elections and with the new dynamics will likely not pass a major package.

These four threats could significantly impact the economic recovery which had already started to falter because of the resurgence that we saw in September. The economy is on borrowed time. Unemployment support has already ended in September. Many businesses had pinned their hopes on recovery during the holiday season. If the holiday season fails to meet expectations, there will likely be a flood of business closures in Q1 2021.

The economic situation will get better after Q1 as vaccines become available, a stimulus (of some sort) is passed, and the weather gets better. But until then it will be a very difficult time. This kind of uncertainty is also depicted in the price action.


Market behavior over the past 3 months:


Over the past ~2.5 months we have seen extreme market action within a year of extremes. Equities reached extreme valuations in September followed by a sharp decline (Penta's assessment in September). While the election and stimulus uncertainty continued, markets again rallied sharply into mid-October only to give back the gains by the end of October. The last week of October saw an extreme sell-off as markets realized that there won't be a stimulus before the elections and the elections might be contested.

But then even before the elections were over and the results were out, markets went on a volatile rally which capped with the news of a successful Pfizer vaccine results, to wipe out all the losses from mid-October and in some cases, reach all-time highs (Penta's assessment on the potential end of the decline before the November rally). These volatile movements suggest that the market participants are assimilating a lot of information and trying to make a judgment about the future direction.


Key considerations for portfolio management


While this kind of market behavior can be nerve-wracking, the goal of effective portfolio management is to mitigate these risks and position for the next likely move. This is one such time. While the risks of a sharp correction have suddenly increased, the longer-term economic outlook remains favorable. For any investor this creates a very interesting dilemma, which can be summarized in the following questions:

  1. Should I sell and how much? Why sell especially after clarity from elections and vaccines?

  2. If exit, when to re-enter? What to do if the markets keep going up?

At Penta Capital, we aspire to minimize the aforementioned uncertainty through an AI-driven decision-making framework around investment hypothesis and scenario planning to ensure objectivity in our portfolio management approach. For example, before the elections, we highlighted (link) that the market decline had likely played out. At this point, we are again positioning for a potential decline with tight risk-management in place. While we expect the decline to be short-lived, it could be sharp and significant.


As mentioned previously, our goal is to deliver consistent results aligned with individuals circumstances while managing risks across asset classes and time horizons.


Feel free to reach out with questions.

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