There’s an old adage that the market will go whichever direction inflicts the most pain on the most number of people. So if the crowd expects stocks to go up, then they’ll go down. If the majority of investors are expecting a crash, stocks will rise. While it’s not exactly a science, there’s merit to this idea. The name for it? The “Pain Trade.”
Many expected a crash in 2023
Coming into 2023 many supposed experts were warning of a bad year for stocks. Even today, a simple google search still shows plenty of fear mongering out there:
Yet, what has the market been doing? A balanced portfolio of stocks and bonds is up 5% on the year. The stock market as a whole is up about 8%.
What’s especially interesting is that even after stocks got off to a strong start in January, investor optimism did not increase. That’s unusual; we usually see market sentiment improve as stocks rally. But, a survey of institutional fund managers taken in February saw a large majority calling the market’s January gains, a “bear market rally.” In other words, they didn’t expect it to last.
Two months later, things are still steady and the stock market has added to its January gains. Newer survey data from March showed fund managers remained the most bearish they’ve been in the last 20 years:
On the retail side, TD Ameritrade publishes its, “Investor Movement Index, or the IMX.” The IMX is a proprietary, behavior-based index created by TD Ameritrade designed to indicate the sentiment of retail investors. While retail sentiment has rebounded slightly, it remains near the low end of its 3-year range:
Skepticism towards a rising market is a good thing. If some of these skeptics change their mind and start allocating more dollars to the stock market, they can help fuel further market upside.
Mountains of cash on the sidelines
What might some of these pessimistic investors be doing with their cash instead of buying stocks? Piling into money market funds! Money market funds have near zero-risk and are currently offering 4-5% yields. Investors have found yields quite attractive; assets into money market funds recently hit a record high:
While we don’t see anything wrong with getting 4-5% on cash, we caution against piling into these types of funds at the expense of planned stock allocations. The 4-5% rates today could become 3-4% rates tomorrow once the Fed is done raising interest rates.
By the time you decide to take your money out of money market funds and put it elsewhere, other asset prices could be higher.
Of course, the opposite is also true: you could park cash in a money market and “wait” for stocks to fall. This would be a perfect scenario that allows you to earn risk-free interest and miss out on stock market downside.
But, given that the crowd has rushed into money market funds, such a scenario would go against the rules of the Pain Trade. Rather, the Pain Trade would be for stocks to go higher and money market yields to move lower.
All in all, the market is off to a solid start. The main reason for the strong start is that the economy remains on solid footing. Job growth has continued even as some industries like technology are experiencing layoffs. However, the role of the Pain Trade and its impact on the market should not be understated.
Institutional investors came into 2023 with muted expectations. In many cases, they are trailing the market’s return by large margins. In effect, these types of investors need the market to go down so their performance doesn’t get left behind. The rules of the Pain Trade say that if these investors need the market to go down, then it won’t go down.
Instead, given that many investors are not positioned for, nor expect, market upside, the Pain Trade would be if stocks keep rallying and remain in an uptrend throughout the year.
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