A macro hedge fund investing chief expects a 42% correction in the S&P 500 to play out within a year. He lays out 5 'substantial risks' lurking in the market — and the best way to position for the meltdown (2024)

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1. Investor positioning

Goldman Sachs recently released research notes on both hedge fund and mutual fund positioning in the stock market. In a summary of the notes released on August 27, equity analyst David Kostin highlighted how the two firm types were heavily invested in equities.

The analysts found short interest for the S&P 500 and all sectors sat at near record lows, while gross leverage was at near-record levels for hedge funds, Mutual funds had their lowest cash ratios ever.

This outlook might ring alarm bells for investors who might question how many more investors can move into speculative assets.

It certainly set off alarms for Smith.

"Alas, it appears that too many managers and individual investors alike are disregarding such fundamental principles again just like they did in 2000," Smith said in the note.

As hedge funds and mutual funds position for perfection, retail investor sentiment is picking up and flows continue to move into index funds.

"It seems that investors perceive safety in crowds," Smith said. "Such an investment strategy is fraught with downside risk at high valuations after non-repeatable economic growth inflection points."

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2. Unrealistic growth expectations

Since the middle of 2020, strategists have been making comparisons to the dot-com boom and bust cycle as investors speculated in meme stocks, SPACs and crypto.

And while the comparison might seem tired, Smith thinks it's essential to understand the current outlook and trajectory for the market.

In March 2000, the combined value of the market capitalization of the leading five US companies was valued at a record 24% of the economy based on enterprise value to GDP, according to Smith.

Now the current combined top five, which are all tech stocks, are 37% of the economy based on GDP-to-enterprise value. This is a new record - 54% higher than the tech bubble.

"The whole US equity market is insanely overvalued with the total stock market capitalization relative to GDP far into record territory as we show below," Smith said. "Many other broad market valuation measures are also at historic levels."

The record fiscal and monetary stimulus is unsustainably boosting company revenues, free cash flows, earnings and profitability, Smith said.

"The point is that the largest, most profitable, and highest market cap companies in any business cycle will have trouble sustaining those high growth rates, at least without a major hiccup along the way, to be among the top companies in the next," Smith said, adding that leadership amongst the companies will shift over time.

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3. Depressed earnings yields

Earnings yield is a measure of a company's earnings-per-share over a 12-month period divided by the current market price.

"To use the US stock market as an example, the 5-year cyclically adjusted earnings yield is now near all-time lows," Smith said. "In other words, investors are undeservedly paying excessive prices relative to bottom-line fundamentals."

Using a century of historical data, Smith and his team identified that depressed earnings yields have always led to significant market meltdowns, such as the Great Depression and the 2000 Tech Bubble.

"For every one of these periods, the market unexpectedly reversed from very bullish multi-year trends with an average subsequent 3-year performance of -53%," Smith said.

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4. Inflationary environment and stimulus

One of the drivers for the disconnect between asset prices and fundamentals is the easy access to capital thanks to accommodative monetary and fiscal policy, Smith said.

The record multiples in risky assets is now becoming a constraint for the Federal Reserve, Smith said.

"Ultimately, policy makers have their hands tied and will be forced to counter deflationary pressures in financial assets with further liquidity," Smith said. "Igniting an inflationary environment is the path of least resistance."

Ruffer investment manager Duncan MacInnes, who also believes a significant market rotation is underway, highlighted how even the best performing stocks could be hurt in a high-inflation environment.

If inflation rises faster than interest rates, which Smith expects, then equity fundamental multiples will significantly compress based on valuations of equities versus 10-year real yields in the last 120 years, he said.

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5. The China risk

One major market risk that Smith believes investors are ignoring is the crackdown on domestic companies in China. Just this week, Beijing announced further regulatory crackdowns on gaming, as well as rumors of potential restrictions on Chinese ride hailing companies.

"Asian stocks and the MSCI World index have had a very strong correlation over the years," Smith said.

This correlation could spill into a wider economic deceleration in the rest of the global economy, Smith said.

"In our view, this major decline in Asian stocks suggests a systemic sell-off in global equities ahead," Smith said. " … In fact, the rate of change in US manufacturing data tends to follow the delta in Chinese stocks very closely in the last 12 years. We just had one of the strongest economic environments in history in the last six months and growth seems to be mean reverting."

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How to position

Throughout the note, Smith outlines a number of ways investors can position to protect themselves with a focus on cheap tangible assets.

The firm is bullish on the commodities sector as a whole, which they see as an "attractive investable opportunity". The sector typically performs well in an inflationary environment.

"In our funds, we favor a larger exposure to gold and silver companies, as we remain highly convicted that the underlying monetary metals will benefit the most from the current macro environment," Smith said. "We have a sizeable position in base metals and also hold energy and agricultural companies in our large-cap strategy."

Precious metals companies remain one of the most attractive sectors based on growth, balance sheet strength, valuation and quality, Smith said.

"After the strong smackdown in precious metals that we saw a few weeks ago, gold and silver stocks have firmly rebounded showing signs of technical strength," Smith said.

"The long-term chart of silver continues to look better over time, and we believe it is poised to move much higher in the following months. Gold is also forming a very bullish monthly candle after a major reversal. We expect these moves in metal prices to continue to gain momentum, with miners to lead the way."