The Pros and Cons

I want to take a step back from the surreal action in the market where every dip is bought and take inventory of the pros and cons in the market. I will start with the positives:
  • The economy is improving and like a super tanker it does not turn on a dime. 
  • Companies are generating solid free cash flow and much of this cash flow is being used to buy back stock and buy other companies. This puts a bid under the market.
  • Credit spreads are tight and interest rates are still manageable.
  • There seems to be an ongoing rotation into US stocks, coming seemingly from everywhere else.
Now for the negatives:
  • Professionals such as portfolio managers, advisers and hedge fund managers who de-risked during the Summer have re-risked, leaving less room for them to buy. US stocks which were a big underweight a few months back are now a big overweight. Even mutual fund investors have caught on to this trend.
  • Commodity prices are starting to hurt the bottom lines at companies as they are only able to partially pass on price increases. Many companies hedge their commodity exposure so current prices are not fully being felt.
  • While interest rates remain low bonds are on the precipice of breaking down. This would further hit housing markets and make municipal and fiscal debt burdens harder to bare. 
  • The economic activity we are currently seeing is based on 0% interest rates, printing money and a greater than $1 trillion deficit. This can come back to haunt us at any point.
The reason I have a hard time accepting market risk at this point is that investors are so overweight US stocks that a slight change in risk appetite could lead to large losses even if the fundamentals don't change by that much. The ideal situation would be if something were to occur  that caused investors to position themselves more conservatively but did not effect the fundamentals too badly. With the VIX so low I see little reason not to maintain a hedge at a minimum.

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