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In the first Bulls/Bears Dialogue blog I discussed the standard bull/bear cases we hear every day. But I think there is more to consider if we want to build a clearer vision of where the market may be going.

To some extent this is speculation on my part, but there has been research by the likes of Nomura and Deutsche Bank on the rise of systematic and passive investing. Estimates I’ve seen pin the two at about 80% of market trading volume, with about 60% from passive and 20% from systematic trading. Deutsche Bank has said that systematic trading (robots) has been tightly correlated with market movement this year, and thus they are determining the direction of the market. What have they been doing?

This gets into more speculation on my part. Over previous years, most systematic trading was following growth. The problem is, growth has been slowing (which I believe is why we had that downturn in December). Near as I can tell, this year, while we’ve still seen a love of growth, or potential growth, we’ve also seen momentum and volatility have outsize importance as growth prospects faded. That would explain why tech has been such an outperformer this year. Growth hopes are still strong there, momentum has been good, and, with every dip bought, volatility in the space has been unusually low, particularly compared to history. Thus, tech has been setup to perform wonderfully, as it’s currently hitting all the factors that systematic traders want.

So what happens? In my mind, we’re talking about reflexivity here. Growth, momentum, and volatility are all factors that feed upon themselves. At some point, they hit levels that can’t be beaten. As we saw in December, for instance (at least in my mind and looking at the numbers), growth had pretty clearly been slowing down. This may have been the cause of the violent downturn in markets. Presumably something similar happens going forward. Growth, momentum, and volatility all hit walls eventually where they stop improving.

The favored growth sectors over the last several years have been tech, financials, and industrials. What would I worry about most going forward? Maybe it will surprise some people, but I’d actually worry about industrials the most. They had the weakest momentum in the latest upswing and a high number of earnings misses and warnings so far. All this is making them look the worst of the three in terms of marginal growth potential, momentum, and volatility. Industrials look like the most dangerous place to be right now.

Of the three bullish sectors, the least dangerous right now is probably tech. While there can certainly be individual disasters, all the factors that seem to be getting so much attention are still looking relatively good for now. That said, I wouldn’t touch them with a 10-foot pole. The problem is that at this point you’re picking up pennies in front of a steamroller. While “earnings beats” are getting celebrated, we’re still seeing slowing growth (year-over-year lower earnings for the sector as a whole) and lowered estimates, with the third quarter looking like it will probably be another hard period for earnings growth. Tech may be the last bullish sector to fall, but when it does fall, it’s easy to imagine it will be a doozy.

Could the tech sector wind up in negative YTD performance territory at some point this year? With the sector now up 33% YTD, I’d I expect few people would say yes. But negative performance would only require a 25% decline, which is not too far off of what we saw in the tech sector in the fourth quarter of last year. I think the odds are much higher than most people believe.

So can the market go up from here? Sure, but we should also note a lot of danger signs. What am I invested in? As we saw in December, betting with the robots can turn nasty fast, and Nomura has indicated that some of them are already scaling back, though that may change. Historically, when growth is slowing you want to stay in more defensive sectors, and that’s where we are. For my part, I like staples, REITs, and utilities. They may not have performed as well as tech, but they should be relatively stable.

There is one offbeat thought I’ve wondered about. If the systematic traders continue to focus on the factors of growth, momentum, and volatility, could they start buying the defensive stocks hand over fist? As this earnings slowdown continues, those groups should score well on the favored systematic factors. Maybe that’s an overly self-serving thought, but I wonder.

At some point this bull market will stop. Will it happen now or in 2022? Nobody really knows, but even many bulls seem to admit that the risks are skewed to the downside, they just think we will see more upside first. For my part, and given the warning signs out there, I think it makes sense to be conservative. That hasn’t been the big money call so far this year, but it hasn’t hurt that much either, and I don’t believe we can successfully invest using the rearview mirror of regret. I don’t know the future, but looking at the odds, this seems like an unusually bad time to take a lot of risk.