U.S. markets were rattled this last December and have since rebounded – slightly – while sitting roughly flat. Waiting for some new catalyst to tip investors into either direction.

Usually investors – according to famed macro-trader George Soros – have something called a ‘prevailing bias’. Meaning that they’re gut feeling is either optimistic (bullish), pessimistic (bearish), or neutral (flat). We all have an opinion of what the future holds.

But when the crowd’s bias is leaning one way – that’s the way markets will generally move. For instance – if the crowd has a bullish bias, than investors will shake off bad news and over-rate good news.

Now over the last couple of years – pre-December 2018 – markets had a bullish bias. This kept markets trending higher, even when historical markers (the Tobin Ratio and the Buffet Indicator) showed prices we’re too expensive. And incoming data was bland.

But now things are flat – all while investors try to understand “what’s next”?

There are many big questions up ahead. Such as interest rate and balance sheet decisions by the Federal Reserve, China-US trade talks, and teetering global growth. . .

So while investors stay skittish and look for answers – they play it neutral by pouring into low volatility (lowVol) positions. These are also known as Defensive stocks (such as utilities and telecommunication stocks).

Thinking they’re safe.

And because of this – lowVol U.S. stocks are valued at their highest since at-least 2013.

Putting it simply – Investors are rushing into defensive stocks, overpaying for what they think is going to protect them from any market turmoil.

And while defensive stocks (lowVol) positions do historically perform relatively well during recessions – I think there’s two problems with thinking this today:

First – when investors all think the same way, the trade becomes ‘overcrowded’. Which means paying high prices. And like Howard Marks – Chief Investor of Oaktree Capital – taught us: paying too high of a price is half the risk itself.

And since August when the ‘smart money’ started to transition into Defensive positions – in preparation for the lower growth expectations – there’s been heavy overcrowding as the crowd expects the same. Especially from December’s market sell-off.

A rule of thumb is once market’s are overcrowded, there’s limited further upside and significant downside (what I call negative asymmetry).

And Second – most lowVol companies – like telecommunication and utilities – carry very high debt burdens on their balance sheets. This exposes them to higher interest payments as short-term borrowing costs have risen significantly over the last 16 months – courtesy of the Fed’s hiking.

“… many low-vol names are exposed to high leverage, like utilities and telecoms, which can make them sensitive to higher
rates,” said Roland Kaloyan – head of European equity strategy at Societe Generale SA.

So to summarize:

I think that investors now should avoid the lowVol/Defensive sector as its bid up to very high prices already. The risk-reward at this point looks negatively asymmetric (high risk – low upside).

At this point – with how leveraged the system is –  I’m worried a recession will trigger ‘dollar disease’’ – a concept coined by the deceased economist Irving Fisher. This is when debtors en masse liquidate their assets in a rush to raise dollars so that they can pay off their debts and stay liquid for emergencies (like we saw this during the Crash of 08 and the Great Depression of 1929).

Don’t be surprised if investors dump their portfolios in a race for cash

Defensive ‘lowVol’ stocks included. . .