Speculative Excesses Ramp Up At The Top…

What do these Reddit short squeezes mean in the big picture? In short, they are this bull market’s manifestation of excess: excess liquidity, excess speculation, excess valuation, excess optimism.

The Reddit retail powerhouse is all kinds of other things as well, but from a big picture stance I see it as another big tick in the Volatility Rising column. Volatility usually rises as markets approach tops. I’m not predicting an imminent top but I do think volatility will keep rising from here because of all the excesses.

And volatility has ramification. When it really ramps up, it can be the very thing that kills a bull market.

The Robinhood platform really took flight when folks decided to use their $600 COVID stimulus cheques to play the stock market, because they so well recalled stocks surging out of the Great Financial Crisis and because they couldn’t use the cash to dine out or go on trips.

And we haven’t come far. There will be more stimulus cheques. Stories of stock market success are encouraging more people to jump in. And that’s just the retail side – on the institutional side this long strong market (COVID crash excluded) has created oodles of capital that is largely staying in stocks.

As this continues to build, we will continue to get more and more of the thing that characterizes the late stages of a big market: volatility. Corrections and rebounds will be fast and furious, in particular stocks, in certain segments, and overall.

I say ‘late stages’ but I don’t intend to suggest I have any idea when this setup will change, because I most certainly do not! That said, if volatility does keep rising, it could kill the bull on its own. How? By driving Value At Risk (VAR) models.

These models are key to how fund managers navigate the risk the volatility brings. When VAR rises significantly, funds have to take action (sell) to mitigate.

Big, sustained increases in VAR require big selling. That’s how volatility can push a bull market to its brink. And the potential for such events increases every time the market does something crazy like happened with GameStop and AME.

I see more and more commentary that investors looking to diversify in case of market calamity should consider commodities. Makes sense to me (biased as I may be). Yes, in the case of a major market crash miners will sell off too. But there’s no reason to believe that’s happening tomorrow and, until it does, miners stand out across equities for balance sheet strength and dividend yields.

The overall positive outlook stems from a weak USD, a global inventory re-stocking cycle, a goods-driven economic recovery, and pending/expected infrastructure spending by governments. To those arguments I think it’s important to add supply constraints: capex spending in the mining space keeps trending flat to down despite surging prices and strong demand forecasts. The charts below capture that gap for copper and gold prices versus capex spending (thanks to Canaccord).

I haven’t spoken much about copper (or anything other than gold and silver!) lately, which is not ideal. The price of copper gapped up 25% in six months before starting to settle a few weeks ago. That settling is likely to continue in the near term, as Chinese New Year will reliably reduce buying.

But if copper does dip in the next two months, it will be a buying opportunity. The cyclical and structural outlook is strong over the medium term and copper inventories are actually quite low and have been drawn down to start the year in China, which is the opposite of the usual seasonal trend, as the chart below shows.

I’ve harped on in previous letters about how I think dividend yields will soon start pulling money towards gold miners like bees to honey. At these prices, the same is true of copper miners. Just yesterday Freeport McMoran boosted its base dividend 50% and announced a new capital allocation policy to determine future special shareholder returns.

Barrick and Newmont have done the same in the gold space, where dividend yields now average better than 2%. Copper miners are getting there. And 2% yields attract investors of all stripes, especially when the miners offering these yields have low debts and strong cash flows – factors that, like their strong and rising dividend yields, stand out across equities.

Rising volatility is, then, another reason for investors to seek diversification. Commodities offer that. Yes, in the case of a major market crash miners would get pulled down too. But in the interim…they offer some of the best balance sheets, cash flows, and growth-based outlooks of any equities. So my main takeaway from all things Reddit is that volatility will very likely drive interest in commodities in 2021 as investors look to diversify from the chaos.