Many investors think there are only two options in a market where participants have become overly exuberant, either 'I want in' or 'Get me out.' Our strategies are more nuanced, and we believe fit better with what we expect to transpire.

It used to be that we consulted our favourite market prognosticator—the taxi driver—regarding market tops. When they were touting specific stocks, we knew the end was nigh, but the disruption from Uber and the pandemic has limited our access. Perhaps, in the not-too-distant future, robo-taxis will be equipped to provide stock tips.

From time to time, certain market participants treat the markets as a casino, speculating on outcomes. Others sell at the first sign of market froth as they prefer to be spectators rather than risk exposure to an overdone market. With the ability to perfectly forecast the timing of a recession, one would sell—stepping aside to watch until the bear market ended. Similarly, if one knew a bubble was brewing and could pick the top then aggressively selected positions would benefit most from exuberance. But these scenarios are obviously extraordinarily difficult to predict and fraught with risk. Thankfully, these are not the only options. The point in the cycle, the types of securities being impacted, relative valuations, and other factors play a role in the extent investors should be exposed to stocks when markets are frothy.

The Opposite of Panic

We aren’t sure whether the opposite of panic is complacency, euphoria, or otherwise, but we recognize it when we see it. And we’re witnessing it now. Outright speculation is occurring—IPO shares nearly doubling, on average, on their first day of trading. The IPO boom has now eclipsed that of the dot-com period and many more companies that are unprofitable have gone public than at any point in history. Penny stock trading volume is off-the-charts high too as speculators frantically seek out their next score. And securities trading over-the-counter is being conducted at higher volumes than on the exchanges, which has never before occurred. This certainly can’t end well because most of these companies are early stage, money-losing entities. Trading by individuals has far surpassed the volumes of the dot-com bubble. Margin debt—borrowing to invest—is at an all-time high relative to individuals’ net worth and GDP. So they’re betting using leverage; that’s rarely a good combination.

Meanwhile, short interest is at a record low. The heavily shorted stocks, which usually underperform, are the ones up the most in this recovery and as a group have exceeded any other period over the last 25 years. That has scared off those who typically hedge. Call option purchases have by far exceeded any period historically. Over 90% of market timing newsletters are bullish, invariably a negative sign, and leveraged ETFs are taking on record fund flows.

While we are waiting for herd immunity, the herd seems to be busy playing the stock market.