A major low is ahead of us: Here's how two pros are positioned for it

For all the panic that we have witnessed this year, the S&P/ASX 200 has only fallen 12%. Yes, it's been bad - but it's not a bear market. 

And while professional investors are screamingly bearish - with many pushing their cash allocations to their mandate's limits - retail investors, like you and I, still remain heavily invested. 

That's according to Tribeca Investment Partners' Jun Bei Liu and Watermark Funds Management's Justin Braitling, who believe we need to see retail investors' funds flow out of markets before we see real "capitulation". 

For those not in the know, "capitulation" describes a dramatic drop in market prices, as investors start unwinding positions en masse to avoid further losses - as in, surrendering to the fall in markets.

This could be in the last few months of the year, or sometime in 2023, Braitling says. But how these two long/short fund managers are tackling this heightened volatility, and ultimately, a market low is remarkably different. 

Here, Liu and Braitling share what investors can expect over the next 12 months (which could include a rally into the year-end), as well as how they are currently positioned for a further sell-off in markets. 

Jun Bei Liu

Lead Portfolio Manager Alpha Plus Fund

Tribeca Investment Partners

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Justin Braitling

Chief Investment Officer

Watermark Funds Management

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Most of the market is bearish right now. If everyone is sitting on a lot of cash and positioned for a further drawdown in markets, who is left to panic sell? How does this impact liquidity in markets?

According to Liu, market liquidity has been steadily falling since the beginning of the year - and more recently, we have witnessed some of the lightest trading volume days in years. 

"Lower liquidity has now led to higher volatility in share prices - that’s why we often see small earnings announcements tend to lead to severe price reactions, not allowing proper price discovery to take place," she explained.

"This simply means that stock research has become incredibly important as valuation discrepancy rises." 

Meanwhile, Braitling believes there is good reason to expect the market to rally into the year-end.

"Everyone is bearish and activity has not really started to slow yet, and the data may stabilise in the short term," he said.

"I like to be mindful of sentiment and positioning but not overstate its importance. It is not typically a good signal for market timing. While positioning is light for institutional investors and hedge funds, leverage and retail participation are still high, by historic standards." 

After all, around US$1 trillion of retail investor savings flowed into shares globally during the COVID crisis - and Braitling believes much of this money is still invested. 

"Margin debt balances, which are also very high reflect this," he said. 

Despite the sell-off we have seen in equities markets - both locally and globally this year, Braitling said the technical signs of "capitulation" are still missing. 

"The selling in June and September was remarkably orderly. You can see this in the VIX Index (a key volatility measure), as it never spiked above 35," Braitling said.

"When the real capitulation happens next year, prices will fall heavily, and ETF and SPDR volumes will spike higher along with volatility measures as retail money comes out of the share market. There is a clear technical signature for capitulation which has been missing, a reason why a major cycle low is still ahead of us."

2. Which signals are currently highlighting the overall bearishness of the market? 

Commonly used indicators of overall bearishness like the VIX, Put/Call ratios, and the relative strength index (RSI) suggested we were approaching a short-term low in early October, Braitling explained.  

"The prior June low was tested and held in offshore markets - this was all part of a corrective rally from the June low which will complete around year-end, probably when everyone is on holiday if history is a guide," he said. 

"By this time next year, the low is probably in, and we will be into the next cyclical bull cycle within the broader secular bear trend (we won't make a new high like December 2021 - that may take many years to come)." 

Right now, fund managers are sitting on as much cash as possible, Liu adds, which can provide investors with a helpful indicator of professional investors' outlook on the market. 

"However, one of the more interesting and perhaps more predictive indicators is retail investor equity holdings," she said. 

"We have yet to see retail investors capitulate across most markets even though institutional investors have derisked meaningfully. This probably means we could see further downside if markets continue to be volatile."

How much cash are you personally sitting on right now? What does your mandate allow?

Both Braitling and Liu run long/short portfolios or hedge funds and as such, can benefit from both bull and bear markets. For more on the cash holdings of long-only fund managers, check out this article by my colleague Chris Conway. 

As for Liu, Tribeca's mandate allows the fund to hold up to 10% cash - however, she notes she would never hold more than 2%. Currently, the portfolio's allocation is 0.5% cash. 

"This provides us with additional capital to buy higher quality companies during market dislocations."

Meanwhile, Braitling is currently fully hedged (100% cash). 

"Our substantial long portfolio is fully hedged with a short portfolio of similar size," he said. 

"It doesn’t matter whether the market goes up or down, we benefit to the extent the shares we own (long) outperform the shares we are short - we capture the spread." 

If everyone is bearish, is it time to be greedy? What needs to change for you to want to dive in?

Braitling's cycle analysis currently suggests that the market will fall "heavily" next year - but notes that it "is possible" this drawdown occurs in the last few months of 2022. 

"A major low has a signature of capitulation which has been missing," he said.

"Right now, the Australian share market is still only around 10% off its December high, industrial shares are still expensive at 17 times earnings and we have a major contraction in the global economy ahead of us. 

"The opportunity is to sell this next rally into year-end, not to buy an expensive market because sentiment is poor. And it's poor for a very good reason." 

Liu disagrees, arguing there are compelling opportunities in the market right now, particularly for quality stocks, comparable to those seen at the onset of the pandemic. 

"Most investors are waiting for the stabilisation of the long-term bond yield to mark the entry point of many companies," she said. 

"My view is, that point is probably not very far away. Do the homework and find those businesses you want to buy and just buy them when price is right. Don’t wait for the market to find reassurance. That’s how the smart money is made." 

Want more content like this?

Well, lucky you. This is the second wire in a three-part series featuring Justin Braitling and Jun Bei Liu. Next up, you'll be learning about the signals (and stocks) to watch when markets pivot. In case you missed it, check out this piece on how to navigate bear market rallies. 

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