The other reason so many portfolios are bleeding

In a share market as bifurcated as the ASX, leading indices such as the ASX200 or the All Ordinaries no longer show investors the true picture of what is going on.

On a three-month view, share market indices have shown increased volatility, but on balance, the direction has remained upwards. The ASX200 moved away from 6,600 as many times as it was able to, only to be pulled back towards it an equal number of times, sometimes quite violently.

On Monday, Australia's leading index closed at 6,739.60, which is pretty much in the middle of the 6,600 to 6,900 trading range that has kept the local market in check since late last year.

Underneath all that day-to-day volatility, however, lays a gamut of portfolios and market positions that are bleeding profusely and in a lot of pain. Share prices for companies including Cochlear (COH), Nanosonics (NAN), Altium (ALU) and Coles (COL), to name but a few, are trading well below levels witnessed last year.

The easy explanation that roams the internet these days is "rising bond yields", often with an extra reference to previously bloated valuations. In some cases, such excuses also reference the disappointing operational performance revealed in February.

It is why shares in Magellan Financial (MFG) are now down more than 36% from last year's high, and the damage has even been greater for Bravura Solutions (BVS), or for Appen (APX), while the likes of Afterpay (APT) and Zip Co (Z1P) are rapidly catching up, so to speak.

The easy explanation, however, is only part of what is inflicting so much pain on market segments outside of this year's re-opening and reflation trades. While many an expert had been reflecting upon the likelihood of higher bond yields for 2021 and possibly beyond, very few would have anticipated we'd see Australia's 10-year bond aiming for 2% by the end of February - despite the RBA temporarily putting a stop to it.

In the US, the world's largest market for government bonds by a long stretch, the yield on the 10-year loan has now nearly tripled from below 0.60% to now 1.55%, with the occasional attempt to move above 1.60%. Back in 2012, the most recent reference to bond yields rising and weighing upon equity markets, those yields rose from 1.5% to 3% - a level much higher in absolute terms.

But a similar rise today would represent a near quadrupling in yields from the bottom, while 2012 saw merely a doubling. 

Context is all that matters in finance, and relative values and movements are more important now than in the preceding decades since yields are at ultra-low levels and debt at an unprecedented high.

Many a market analysis has put central banks in the global control room, keeping liquidity flowing and bond yields low, allowing equities and other assets to remain in bull-market mode. So, it's no surprise that many on Wall Street look to the Fed to stop this year's bond market shenanigans from inflicting so much pain on REITs, healthcare stocks and technology-driven business models. But so far, there's been no intervention, similar to what we've seen with the RBA locally.

For this to happen, policymakers at the world's most dominant central bank would need to become a lot more worried that selling of US Treasuries (yields rising) might become unruly, possibly out-of-control. This could have a negative influence on market stability and the central bank's ultimate policy goals, which now include allowing inflation to sustainably run above 2% for an undetermined period of time.

As with the RBA, the Federal Reserve will only intervene when it feels market stability is in danger. This might impact the strength of the nascent economic recovery, weakening the labour market and finances of the US government and the average US household. While rising US bond yields are seen as the natural correction from exceptionally low yields in response to COVID-19 and last year's global recession, central bankers need to be careful they communicate well and their messages are not being misconstrued or misunderstood.

Most importantly, market participants need to remain fully confident Phillip Lowe, Jay Powell and fellow central bankers know what they are doing and remain in full control over what is happening in divergent corners of the financial world. One of the narratives, I feel, that is currently read differently from the Fed's intention is that, longer-term, letting inflation run past 2% means bond yields can run a lot higher in the meantime.

This looks like the first miscommunication that needs to be addressed and Jay Powell might well make the extra-effort after the upcoming FOMC meeting, scheduled for March 16-17. But from an economist's viewpoint, let alone from the world's most-watched central bankers, there doesn't seem to be a lot to be overly worried about just yet.

Yes, some share prices are down, but others are up, and the economy seems to be humming quite nicely, adding more jobs each month. While things have become a lot more volatile over the first two months of the fresh calendar year, they are a far cry from the mayhem and the emergencies that kept on popping up 12 months ago.

While the RBA felt it had to show its hand when domestic bonds rallied past 1.9% in a hurry, the Federal Reserve will be very reluctant to follow suit. Theoretically, it could go down the policy path of Japan, and the RBA in Australia, and put an effective yield control policy in place, or increase its own bond-buying program. But the Fed prefers to use such options only when its communication with market participants fails.

And so the speculation can run rife in the meantime. What is he going to say? Will he say anything? I'm siding with those who believe central bankers will hold on to their communication that inflation, underlying and in trend terms, still has a long way to go until it reaches the current goal of 2% and beyond - even though this year might see a small but temporary spike because of the economic recovery.

Whether such communication will be enough to keep the bond market in check remains anyone's guess, but we'll soon find out.

The other factor: Portfolio disruption

It remains true that rising bond yields put pressure on higher valued stocks. 

And until recently, segments of the equity markets in both Australia and overseas showed all the signs of ultra-exuberance - all while some investor cohorts pretended valuations were meaningless and that prices can continue to rise no matter what.

But share prices of many quality companies that released excellent results in February, accompanied with ongoing buoyant guidance, are falling virtually every day, leaving valuations derived from analysts' forecasts 25%, 30%, or even 40% higher. Surely, even if fundamental models need to incorporate higher yields, valuations for the likes of Charter Hall (CHC), NextDC (NXT), and Hub24 (HUB) will still remain significantly above where share prices trade?

The answer is yes, but that won't necessarily mean present market dynamics cannot last for longer. One important part of the puzzle can be explained by looking at the positioning of investment portfolios at the start of 2021, many loaded up with technology and growth, while financial and cyclical stocks were the outperforming segments.

So what investors are experiencing in the first quarter of 2021 is, essentially, portfolio disruption, explains Morgan Stanley's US-based equity strategist, Michael J Wilson. This is why shares in CSL (CSL), Goodman Group (GMG), Afterpay and the like need to be sold to purchase shares in, say, Orocobre (ORE), Bank of Queensland (BOQ) and Downer EDI (DOW). This has created the big swing in momentum between divergent parts of the market.

Wilson thinks this process still has further to run, as portfolios need more recalibrating towards Value and cyclicals. Just as importantly, banks, miners and other cyclicals will soon look great on technical charts, while the technical picture for share prices under pressure is breaking down. This will further widen the gap as short-term traders (and others) will continue to feed the momentum.

I believe that recurring chatter among traders is how the Nasdaq is forming a "reverse head-and-shoulders" on price charts, which is widely interpreted as the harbinger of much weaker index levels.

Ultimately, predicts Wilson, "Growth stocks can rejoin the party once the valuation correction and repositioning is finished", but one can sense this can still take a while, irrespective of whether the Fed calms the market next week, or not.

Active Managers' January Survey

Meanwhile, the latest update on active funds managers in Australia by JP Morgan shows average cash weightings continue to trend down with January the tenth consecutive month of cash draw-downs; cash is now at a new record all-time low of 2.2%. According to the survey, cash levels fell by a further -27bp in January and are now -147bp below the two year-average.

In February last year, average cash rose to 4.5%, the same level where it was in the first half of 2019. BHP Group (BHP) and other iron ore miners have been the trade du jour in January with the survey indicating some 70% of local active managers own BHP as a top holding in their portfolio. Another popular come-back stock has been Westpac (WBC).

The number of technology stocks dropped in January with the sector only representing 3.2% of major positions in portfolios; the lowest percentage point in six months. The most popular domestic tech stock among active managers remains Xero (XRO).

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