What a difference a year makes, as markets are once again in rocket mode with quite the Santa Claus rally to end 2023.

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Markets are bullish, but there are smarter ways to play than going all in Back to video

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It isn’t a coincidence this has happened at the same time the United States Federal Reserve turned dovish, giving investors the go-ahead to add risk back into their portfolios. As a result, the U.S. Financial Conditions index has now fallen over the past two months by the most since COVID-19 and the global financial crisis.

Speculators have also returned en masse, plowing into the riskiest segments of the market as the top performers since the Fed’s mid-December update have been unprofitable tech stocks, special purchase acquisition companies (SPACs), companies with bad balance sheets and the most shorted companies, according to the Financial Times. Even the highly volatile Ark Innovation ETF’s unit price rallied more than 50 per cent from its end-of-October lows.

Meanwhile, the Dow Jones has set new highs in 11 consecutive years, just one year short of its 12-year run prior to the tech bubble bursting in 2000. Not surprisingly, global fund manager sentiment is very upbeat, with investors being the most overweight stocks since before the Fed began hiking rates, according to Bloomberg. Cash allocations have been reduced to a two-year low of 4.5 per cent, while fund managers are the most overweight on bonds in 15 years.

Further evidence that this is a pure duration bet on falling inflation and rates, fund managers are also the most bearish on commodities they’ve been relative to bonds since March 2009. This lines up with recent Commodity Futures Trading Commission data that shows hedge funds have reduced their oil long positions to the lowest ever recorded in data going back to 2011.

Lopsided markets scare us. We’ve learned to expect the unexpected when the consensus thinks they’ve got it all figured out. We’re not alone.

“Rather than being inclined to opt for the easy shortcut associated with the ‘it just took longer’ narrative, both markets and policymakers would be well advised to focus on how much the world has changed in the past few years,” Mohamed El-Erian, former chief executive of Pacific Investment Management Co., said in a recent Financial Times column. “The inflation round trip is neither simple nor complete. The resulting shift in the configuration of the global economy and financial markets will be felt for several years.”

Therefore, our advice is to enjoy the Christmas gifts we’re being given by the markets at the moment, but act prudently after New Year’s Day. Going all in on the riskiest segments of the market should be left to day traders and speculators.

Investors’ time is better spent looking for the underappreciated areas of the market and, fortunately, there are plenty because 71 per cent of stocks in the S&P 500 are still underperforming the index, the biggest percentage since at least 2000, according to financial blogger Callie Cox.

We also like the beaten-up commodities sector, which currently offers a very inexpensive way to protect against any resurgence in inflationary pressures should the U.S. not enter a period of economic weakness. There is also the potential for supply disruptions with rising escalations in some of the world’s largest oceanic routes.

From a bond perspective, we’re adding duration to our portfolios, but with embedded downside protection in the event we get it wrong and central bankers, especially the Fed, don’t meet expectations for rate cuts. We’ve recently done this on 20-year Treasuries via a structured note that will allow us to participate in the upside by 120 per cent, but with a 20 per cent downside barrier.

We’ve also done structured notes on various market segments, especially interest-sensitive segments such as utilities and pipelines, again with downside barriers, that will benefit from lower rates here in Canada.

We haven’t sold any of our energy exposure despite the tremendous volatility this past year, and even more so over the past few months. We think there was an overplay on seasonality, setting up the potential for a large swing to the upside should any unforeseen event cause the shorts to cover.

There are plenty of opportunities to rebalance portfolios by reducing areas that have outperformed, such as the tech-heavy S&P 500, and reallocating into underperforming areas like the S&P/TSX composite. That said, we still like the U.S. dollar, especially with the recent run-up in the Canadian dollar, which we think is at the top end of its range.

Martin Pelletier, CFA, is a senior portfolio manager at Wellington-Altus Private Counsel Inc, operating as TriVest Wealth Counsel, a private client and institutional investment firm specializing in discretionary risk-managed portfolios, investment audit/oversight and advanced tax, estate and wealth planning.

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