The Big Picture

With the S&P 500 and Nasdaq Composite stretching to new highs seemingly every day on the back of mega-cap strength, one might be inclined to think that the so-called "pain trade" is for the market to move lower.

Those moves, though, have triggered a lot of chatter about the market being overbought/overextended and due for a pullback, if not a correction (loosely defined a 10% pullback from a prior high). 

We would venture to say that that is the majority view right now. When most people think something will happen, and it doesn't, you get a pain trade because it hurts for so many to watch the opposite unfold. In brief, a pain trade is the trade that hurts the most people.

This is a devious dynamic of the equity market. It can unfold in individual stocks, industry groups, and/or at the index level. It can also unfold at the economic level, and based on a recent survey of fund managers, there could be a real pain in the asset trade if the economy does not perform as expected.

A Real Nugget

The BofA June Global Fund Manager Survey was released June 18. There were some notable findings:

• Global fund manager sentiment is the most bullish since November 2021.
• Cash levels are at a 3-year low (4.0%) but remain at a neutral level in terms of being a contrarian indicator.
• Only 8% of respondents say the Fed won't cut rates in the next 12 months, whereas 8 of 10 investors expect 2, 3, or more rate cuts.
• Being long the Magnificent 7 is the most crowded trade since the long U.S. technology trade in October 2020.
• The allocation to technology has fallen to a net 20% overweight, which is the lowest since October 2023 and below the long-term average of a net 22% overweight.
• Investors are the most underweight bonds since November 2022.

Key to our discussion this week, however, is this nugget:

• Just 5% of respondents see a hard landing for the global economy in the next 12 months (while 53% don't see a recession for the U.S. economy in the next 18 months).

For some added perspective, 30% of respondents in October 2023 saw a hard landing for the global economy in the next 12 months. These are halcyon economic times, then, as far as most fund managers seem to be concerned. Only 5% expect a hard landing.

Any guesses what the pain trade might be for the economy? That's right. A hard landing would be the pain trade since so few fund managers expect it. Most expect a soft landing (64%) or no landing (26%).

To be fair, most have been right so far. The global economy has performed admirably following a tightening campaign by many of the world's leading central banks, which, for some, has run its course.

Now, with some central banks starting to cut rates, and the Fed at least suggesting another rate hike is unlikely, there is a belief the global economy will escape the throes of a hard landing absent an exogenous shock.

Something Less Bad

But what if the vast majority of fund managers are wrong? What if their thesis turns against them, and the lag effect of prior rate hikes hits in a meaningful way and the U.S. economy, which is the engine of the global economy, suffers a hard landing?

In short, that wouldn't be good. For investors, it would be less bad if they opt to build in some hedging for that possibility ahead of time.

That doesn't mean selling everything and going to 100% cash. That sounds safe, and is safe in theory, but it would include paying capital gains taxes in non-qualified accounts, paying trading commissions in some cases, and it potentially introduces a high opportunity cost if the economy doesn't suffer a hard landing and/or there is a reluctance to reinvest the cash.

There is a cost to playing it completely safe, which in hindsight after a hard landing always looks worth it. How safe one needs to be or wants to be in front of a possible hard landing, though, will have a lot to do with when they might need the capital in an investment account.

What It All Means

We have been emphasizing the theme of risk management in recent columns. This week's entry falls along those same lines.

We are not making a forecast here. Rather, we are highlighting two things:

1. The current views of global fund managers; and
2. How one might go about building in some hard-landing hedging for their investment portfolio to mitigate the risk of loss in an economic pain trade should one come to fruition

Some simple and popular approaches would include the following:

• Increase cash allocation
• Add Treasury exposure (shorter-dated Treasuries would benefit from policy easing measures to combat the economic weakness, and longer-dated Treasuries would presumably benefit from lower inflation stemming from weak demand, safe-haven interest, and dare we say quantitative easing)
• Underweight deep cyclical sectors like materials, industrials, and energy
• Overweight countercyclical sectors like consumer staples, health care, and utilities
• Stick with the highest-quality companies across market cap size, but overweight the highest quality, large-cap companies
• Look to REITs and dividend-paying companies for income opportunities (i.e., quality companies that have had steady dividend growth as opposed simply to companies with a high dividend yield)
• Add some gold, which doesn't generate income but is typically regarded as a store of value option during a recession

It is never easy to watch stock prices and/or the market go down in a meaningful way -- even when the starting point is from a record level. Lower prices are painful, but arguably they are the most painful when they are least expected.

That's because there is offside positioning. Quick losses associated with a news catalyst can trigger a sell first, ask questions later mentality that exacerbates the selling pressure along with margin calls and stop-loss orders. When a recession trade kicks in, it's not so much that there is rapid-fire selling as there is steady selling pressure and an inclination to sell into strength as investors lack faith in earnings prospects.

The extent of any pullback will have to do with whether it is a shallow recession or a deep recession. The latter would be the hard landing, which would invite the pain trade because so few expect it, meaning so few are positioned for it. There are ways to get in position ahead of time, however, if you fear the hard landing so few see coming is going to happen.

--Patrick J. O'Hare, Briefing.com