Stocktake: Traders get high on pot stock

Like volatility? Then forget cryptocurrencies and get into cannabis stocks. Canada is to legalise medicinal cannabis next month, a move that has triggered especially demented trading in pot stock Tilray. The company, which debuted on the Nasdaq at $17 in July, hit $300 last Wednesday. Put another way, a $10,000 investment in the company would have grown to over $170,000 in two months.

That's even nuttier than last year's cryptocurrency madness, with Bespoke Investment noting that bitcoin "doesn't hold a candle" to Tilray's gains. Wednesday's trading was particularly hilarious. The stock, which closed at $155 on Tuesday, almost doubled before topping out at $300. It then collapsed and was briefly down on the day before rallying once more, ending the day up 38 per cent. Trading was halted five times during the day. Tilray is not a micro-cap stock – far from it. Backed by billionaire investor Peter Thiel, it was worth $28 billion at Wednesday's peak. That's higher, noted Pension Partners' Charlie Bilello, than 301 of the S&P 500's stocks. If Tilray continues at this pace, Bilello added, it will surpass Apple as the world's largest company by Christmas.

As one observer quipped on Twitter, we humans are a special type of creature.

Fund managers turn fearful

Contrarians who like to buy when investors are fearful will be intrigued by Merrill Lynch’s latest monthly fund manager survey, with pessimism about the global economy now at its highest point since the European debt crisis in 2011. This nervousness is reflected in cash balances climbing to an 18-month high of 5.1 per cent, well above historical norms. Global equity allocations are near their lowest levels in 18 months, although there’s no hint of panic in the air; current allocations remain only slightly below normal levels. Similarly, investors are increasingly wary of Europe, where allocations have fallen to 18-month lows, but not so wary that contrarians will be tempted to dive in. Current allocations remain near historical norms, with Merrill expecting sentiment-driven rallies to be “short-lived” affairs. However, contrarians will be tempted to underweight the US, where bullishness has hit excessive levels. The number of investors overweighting the US has hit its highest level since January 2015 and is well above its long-term average, while optimism regarding US corporate profits has hit 17-year highs. The obvious contrarian bet is to overweight emerging markets. In April, emerging markets was the most favoured region among fund managers. Now, having fallen into a bear market, investors are desperate to get out, with allocations plunging to their lowest levels since March 2016.

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Odds favour emerging markets

History also suggests that the "buy when there's blood on the streets" approach is a good one when it comes to emerging markets, according to Schwab's Jeffrey Kleintop. Although the current bear market – defined as a fall of at least 20 per cent – is an unpleasant affair, investors should remember sharp falls are part and parcel of investing in emerging markets. Emerging markets are roughly twice as volatile as the US market, notes Kleintop, and have fallen into bear markets in seven of the last nine years.

The good news is they have delivered the goods over the long term, averaging annualised returns of more than 10 per cent. Furthermore, they tend to “rapidly bounce back” after major declines. After dropping 20 per cent, an index of emerging market stocks is “usually up double-digits just six months later”.

There are exceptions, of course, and Kleintop admits a “prolonged downturn” is certainly possible, but history suggests now might not be a bad time to emerging markets.

Time to rotate out of US stocks?

The case for rotation out of US markets is also made by JP Morgan’s chief quant, Marko Kolanovic, who says the corporate tax giveaway and the delayed positive impact of last year’s weak dollar has created a “sugar high” for US stocks in 2018. Kolanovic expects economic fundamentals between the US and the rest of the world to converge in coming quarters.

As stock markets tend to price in fundamentals by six to 12 months, “the time for rotation may be now”. Certainly, the extent of the recent US outperformance has been remarkable. The US has outperformed global equities for the entirely of the ongoing nine-year bull market but has “really ramped up its outperformance over the last few months”, Bespoke Investment noted last week.

Still, investors should be careful not to assume that such streaks are inherently unsustainable. Ned Davis Research recently examined the 10 previous cases where US indices had trounced international stocks by 2018-like levels. A year later, the S&P continued to outperform non-US markets on seven occasions. Even more notably, the S&P 500 was higher every single time, averaging gains of 17 per cent.