Equity Positioning, Sentiment and the Disposition Effect

KCR’s work leans heavily on sentiment for good reason. The presence of our in-house academic and co-founder does not mean we are advocates of efficient markets. Much of the research in behavioral finance that our systematic approach to fundamental research leans on is dedicated to finding undue pessimism and optimism. These are often a critical ingredient in generating outsized returns.

Our CFTC “Are Cleantech Stocks a Short?” spoke to this directly. In that work, we highlighted how investors’ rampant over-optimism for unproven “clean tech,” despite awful fundamentals and excessive equity positioning had set investors up for disaster. While the average stock we panned has plunged -40% since publication, we believe that work merits revisiting. There are still many stocks in that list that might have further to fall.^[1]

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Recently, the wonderful Topdown Charts put out a fantastic thread on the dispersion between equity positioning, sentiment, and cash balances. The chart below is terrific, and the subsequent walk-through illuminating. Their thread highlighted how equity sentiment was at 2009 lows, but equity positioning had fallen only slightly. A later chart in the thread shows much of that selling appears in increased cash balances.

Source: Topdown Charts, Refinitiv, ICI, AAII, II

Looking at the distribution of equity valuations, KCR has a hunch about what happened here.

Investor pessimism appears to have manifested itself in one of the most pernicious applications of behavioral finance – the disposition effect. This is when we sell our winners and hold our losers to avoid the mental pain of taking a loss. Who have been the biggest winners this year? Energy and their near neighbors like fertilizer.

Any of the energy stocks we have advocated for since early ’21 would work perfectly but let’s look at CF Industries. This fertilizer stock has soared 70% since we wrote it up in October last year. Would you want to be long that chart? The sentiment must be incredibly bullish right? We think not, let us explain.

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Let’s drill down one layer. Nikkei Asia’s recent article Farming Out: China’s overseas food security quest explains China’s ever more aggressive pursuit of food security amidst drought and energy shortages. They note that the nation’s drought is so severe that:

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SOURCES

^[1] In our piece “Investors’ Long Term Stock Forecasts: A Perfect Path to Poverty” we highlighted the autocorrelation between trailing three year returns by sector and investor sentiment and called for a reversal. The results speak for themselves.

^[2] We are aware that the CAPM formula would suggest that Tesla’s cost of equity is higher than CF’s. We can see this just using the Bloomberg WACC feature. This cost of equity is inconsistent with Tesla’s valuation.

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As a reminder for our Financial Advisors: our models are available on a continuous basis, and most have been in production for over a decade. If you are looking for simple, concentrated, low turnover, and tax efficient model portfolios we would like to talk with you. KCR also offers a wide range of easy-to-use but sophisticated tools. Our toolkits can help identify mispriced stocks with the best and worst risk/reward characteristics, estimate a stock’s duration and warn you when a company is engaging in low-quality accounting. Over the last 12 years, KCR has built and offers time-tested and class-leading products built by experienced and proven money managers for fixed to low prices.
Kailash Capital’s sister company, L2 Asset Management, runs market neutral, long/short, large-cap, and mid-cap long-only portfolios with a value and quality bias. L2 employs a highly disciplined investment process characterized by moderate concentration, low turnover, high tax efficiency, and low fees. While nobody can predict the future, we believe the recent resurgence in risk-adjusted returns seen across all products is the beginning of what may be a long period where speculation is punished, and prudence and patience rewarded.

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