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Actionable Insights

• Quality small-cap stocks are now trading at a significant discount to comparable large-caps.

• History indicates that timing the market based on yield curve signals is exceedingly difficult.

• A sin-weighted portfolio generated an annualized Fama-French 6-factor alpha of 4%.

• Buybacks signal confidence and attract capital to undervalued firms, thereby increasing long-run shareholder value rather than destroying it.

The lost decade for small-cap stocks

U.S. small-capitalization stocks have now underperformed large-capitalization stocks for a decade, a reversal of the historical small-cap premium. Recent analysis by Vanguard suggests several structural factors behind this shift.

• Smaller companies, as a group, have seen deteriorating quality: as of mid-2025, almost one-third of Russell 2000 companies were reporting losses, whereas large caps maintain far higher profitability.

• Sector composition has also played a role: large-cap indices are far more tech-heavy (37% of the Russell 1000) than small-cap indices (only 12% tech).

The silver lining is that small-cap valuations have fallen to very attractive levels. By mid-2025, quality small-cap stocks (profitable ones) were trading at a significant discount to comparable large-caps.

Vanguard’s capital markets team now projects that U.S. small-caps will outperform large-caps by ~1.9% per year over the next decade.

Active managers are already leveraging this mispricing: 18% of active small-cap blend funds beat their benchmarks over the past 10 years, vs. only ~6% of large-cap blend funds.

Source: Fading small-cap premium and softer U.S. labor market (Vanguard)

Yield Curve Investors and Stock Returns

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Actionable Insights

• A 60/40 portfolio grows more slowly than an all-stock portfolio, but it provides important protection during downturns. Over the past 150 years, stocks faced 19 bear markets while a 60/40 mix only encountered 11. In serious crises like the Great Depression, the 1970s, and the 2000s, losses in a 60/40 portfolio were often about half those in stocks. This shows that mixing bonds with stocks can lower risk while still allowing for long-term growth.

• The U.S. housing market is slowing mainly because homes have become too expensive, not because of financial instability. Most owners are sitting on low-rate mortgages and don’t want to sell, while buyers face record-high payments that are pricing them out. Sales and price growth have both cooled, but unlike 2008, household finances are much stronger, so any drop in prices is likely to be slow and limited rather than a sharp crash.

• A small group of companies now controls nearly 40% of the S&P 500's market value. This creates a false sense of diversification. While investors may think their portfolios are well spread out, the significant influence of a few firms means that shocks specific to those companies or sectors can greatly affect returns. Notably, strong index representation doesn't mean strong performance, as many Mag7 stocks underperform much of the broader market.

• Since 1945, stock price movements have changed significantly. Companies have cut payout ratios from over 90% to below 50%, choosing to reinvest earnings instead of giving them out as dividends. This has increased the duration of equities and made prices much more sensitive to changes in expected returns. Nowadays, expected returns explain over 90% of market price variation, while dividend growth plays a smaller role.

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Actionable Insights

• The Morningstar Global Markets ex-U.S. Index has delivered more than double the return of the U.S. market in dollar terms. Europe, South Africa, and Asia have all posted strong gains, showing that diversification beyond the U.S. is paying off.

• The IRS’s decision to delay form changes until 2026 will lead to larger refunds early that year, likely giving spending a short-term boost. Since the benefits are skewed toward upper-middle-income households, much of the money will flow into discretionary items. GDP may get a lift in early 2026, but the effect will fade quickly, so investors should not view it as a lasting driver of growth.

• Global real estate stayed resilient in Q2 2025, with strong deals and fundraising. Residential led with steady demand and rents, offices benefited from selective large deals, industrial slowed under trade pressures, and retail recovered on healthy spending. Overall, the sector continues to provide stability and reliable returns.

• In Q2 2025, jewellery demand fell 14% year-on-year, while ETF inflows surged 170 tonnes and bar and coin investment rose 11%, underscoring that gold’s momentum is being driven by investment flows.

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Actionable Insights

• Some actively managed funds boost returns by buying illiquid stocks, creating a cycle called “Ponzi flows” that attracts more inflows. This cycle can lead to sharp losses when inflows slow down. ETFs that dramatically outperform during inflow surges often experience significant declines afterward.

• The type of investment fund and its investors affect how corporate bond prices move. OEMFs can push bond prices down when many investors withdraw at once, forcing quick sales. ETFs can ease that pressure since shares trade on the market, but if mostly held by institutions, they might make prices more volatile.

• Large institutions and ETFs trading near the market close create temporary price pressure that often causes stocks to reverse their earlier moves. This end-of-day reversal is driven by trading activity, not changes in fundamentals, and explains short-term price swings at the end of the day.

• Bitcoin’s steady 31% gain in Q2 and its 53-day stretch above $100,000 show growing stability despite economic challenges. More companies adding Bitcoin to their treasuries suggest it’s being seen as a long-term asset. With supply still tight, any increase in demand could lead to quick price moves.

• The first half of 2025 brought major shocks like DeepSeek-R1’s launch, new tariffs, and U.S. debt downgrade, but global markets stayed strong. Traditional strategies may no longer be effective, which makes private equity, inflation-linked credit, and real assets appealing alternatives. Including these options can help improve returns and build stronger portfolios in today’s market.

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This isn’t a ponzi scheme… but it kind of feels like one

Some actively managed funds may be generating strong returns in ways that resemble the mechanics of a Ponzi scheme. The gains aren’t driven by improving fundamentals, but rather by the price pressure created by their own buying.

A lot of these funds hold large positions in illiquid stocks. When new money comes in, it’s used to buy more of those same stocks. That extra demand drives prices up, making the fund’s performance look even better.

As returns rise, more investors pile in. Their cash fuels more buying, prices climb further, and the cycle repeats. It creates a kind of feedback loop where money coming in creates the illusion of strong returns. The researchers call this cycle “Ponzi flows.”

Roughly 2 % of total daily fund flows, and between 8 to 12 % of flows into the most illiquid funds, can be linked to Ponzi flow behavior. In dollar terms, about $500 million in investor capital is effectively reshuffled each day due to the price impact caused by these flows.

Funds that rely heavily on this dynamic often suffer sharp losses once inflows slow down. Some have seen drawdowns of over 200%.

The chart above shows what typically happens. ETFs that dramatically outperform the market tend to collapse harder afterward. These “bubble ETFs” surge during the run-up phase but fall sharply once inflows slow.

While these funds may not meet the legal definition of a Ponzi scheme, the effect is similar.

Sources:

1. How to Identify Ponzi Funds? (Quantpedia, July’25)

2. Ponzi Funds (arXiv, May’24)

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How ETFs and OEMFs influence bond volatility

Investment funds like exchange-traded funds (ETFs) and open-ended mutual funds (OEMFs) now play a major role in the U.S. corporate bond market. Together, they hold about 1 trillion dollars in corporate bonds, or roughly 12% of the total market. Even though both types of funds give people access to similar bonds, the way they work and who invests in them can affect how much bond prices move.

OEMFs allow investors to take out their money at any time at the fund’s current value. That might sound simple, but in stressful times it can create problems. If too many people pull out their money all at once, the fund might be forced to sell bonds quickly, even if the market is already falling. That can push prices down even further. This happened during the COVID-19 panic in early 2020, when many OEMFs saw large outflows.

ETFs work a little differently. Their shares are traded on the stock market, so investors can buy or sell without the fund having to touch the actual bonds it holds. This can help reduce the pressure on bond prices during rough patches. But the impact of ETFs also depends on who owns them.

Studies show that bonds with more ETF ownership, especially by retail investors, tend to have smaller price swings overall. But when those ETFs are mostly held by large institutions, the opposite can happen. Prices may become more volatile, especially in times of stress. Retail investors, on the other hand, seem to have a calming effect. This pattern doesn’t show up the same way with OEMFs, where the type of investor doesn’t seem to make much of a difference.

In the end, it’s not just about the fund itself. Who’s doing the investing can matter just as much when it comes to bond market ups and downs.

Source: Fund Investor Types and Bond Market Volatility (International Monetary Fund, March’25)

Think prices reflect the day’s news? Not always.

If you’ve ever noticed sharp moves in stock prices right before the market closes, you’re not alone. Research shows that in the last 30 minutes of trading, especially during the closing auction, stocks often experience temporary price pressure.

This pattern, called the “end-of-day reversal,” shows up consistently. It’s not driven by fundamentals, but rather by how large institutions and ETFs manage their trades. Many of these players aim to execute at the close to track indices or align with their net asset values. That end-of-day rush creates short-term distortions.

And the data backs it up. Looking at U.S. stocks from 1993 to 2019, researchers focused on names listed on the NYSE, AMEX, and NASDAQ, priced over $5, and excluded the smallest 10% by market cap. Every day, they ranked stocks based on returns from the previous close up to 3:00 p.m. (they called this ROD3). Then at 3:30 p.m., they grouped them into five portfolios and held them until the market closed at 4:00 p.m.

The pattern was clear: stocks that had underperformed earlier in the day (shown in dark grey) often bounced back by the close, while earlier winners (light grey) tended to fade. For context, the black line on the chart they used shows the full-day market return, sourced from Kenneth French’s data library.

Sources:

1. Why the Last Few Minutes of Trading Might Matter More Than You Think (alpha architect, July’25)

2. End-of-Day Reversal (SSRN, December’24)

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From volatile to valuable: Bitcoin shows signs of maturing

Bitcoin’s Q2 performance wasn’t just strong. It was steady. After a slight pullback in Q1, the price jumped 31% over the second quarter, ending June at $108,375. But the real story wasn’t the gain itself. It was the fact that, by the end of June, Bitcoin had stayed above $100,000 for 53 consecutive days. For an asset known for its volatility, that kind of consistency was hard to ignore.

This stretch of stability came during a period that wasn’t exactly friendly to risk assets. There were rising tariffs, fears of stagflation, and a long list of geopolitical tensions. Yet Bitcoin held its ground. That raises a simple but important question: are investors starting to treat it differently?

There are some signs that point to yes. In Q2, several companies added Bitcoin to their corporate treasuries. It suggests a shift in perception, with more investors viewing Bitcoin as a long-term holding rather than a high-risk bet.

The price action told a similar story. In April, Bitcoin briefly entered a “death cross,” a historically bearish signal. But it reversed into a “golden cross” just 44 days later. That marked the shortest death cross period since 2015.

One metric that’s worth watching closely is the Illiquid Supply Shock Ratio. It gives a sense of how tight the market could get if demand starts to rise again. As of late June, it remained about 23% below its 2017 peak. That suggests the supply side is already tight. If demand picks up, the price could move fast.

Taken together, these signs suggest the market is maturing. Bitcoin’s ability to hold up despite various headwinds hints that it’s starting to be seen more as a long-term investment than just a speculative trade.

Source: Signals Report (Fidelity Digital Assets, 2025)

Markets have changed. Shouldn’t your portfolio change too?

The first half of 2025 has brought a wave of global and economic shocks that continue to shape the market. In January, the launch of DeepSeek-R1 shook investor confidence, raising concerns about possible disruption to the dominance of the Mag7 tech giants. Then in April, President Trump announced tariffs on 60 countries. Just a month later, Moody’s downgraded U.S. government debt, something that has only happened once before since 1917.

Even with all these challenges, global markets, especially outside the U.S., have shown surprising strength this year.

But investors should not take this as a reason to relax. The days of steady returns supported by low interest rates and low market volatility, which lasted from 2015 to 2021, are now behind us. We are in a new environment shaped by higher nominal GDP, ongoing budget deficits, and rising global tensions.

In this new landscape, older investment strategies that worked after the 2008 financial crisis might not be as effective. Instead of relying on passive strategies that track the market, investors should now focus on long-term themes.

Some of the preferred investment areas today include control-oriented private equity, capital-safe segments of the credit market, and real assets that offer long-term contractual cash flows that can adjust with inflation. These kinds of investments can help diversify a portfolio, protect better against rising interest rates and market ups and downs, and also serve as stronger core holdings compared to traditional options like U.S. government bonds.

Shifting away from the conventional 60/40 portfolio and incorporating more alternatives can enhance returns and improve portfolio resilience in today’s market environment.

Source: Make your own luck - Mid-Year Outlook for 2025 (KKR, July’25)

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Actionable Insights

• Examining the average bid-ask spread alone can give a false sense of security. To truly understand how markets behave under stress, it is also important to track measures such as skewness and kurtosis. These help spot hidden risks by showing how often and how sharply liquidity can dry up, especially in fast-moving markets like equities and FX.

• To better assess economic health, track employment growth within procyclical sectors like construction and business services rather than relying solely on total job numbers. A slowdown in these sectors, even when overall employment is rising, may signal early signs of an economic downturn.

• The dollar and U.S. Treasuries are still at the centre of the global financial system, but confidence in them is starting to fade. It’s not that a sudden collapse is coming, but more people are thinking seriously about what might come next. Eurobonds are one option getting a lot of attention, so it’s something to keep an eye on.

• Passive investing has made markets more accessible and affordable, but it also brings new risks when things turn volatile. Since index funds tend to put more money into stocks that are already climbing, prices can move away from what companies are really worth. Adding strategies that focus on fundamentals or regularly rebalance across stocks can help keep risk in check and support long-term returns.

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Actionable Insights

• AI often gives the illusion of prediction by leaning on what it already knows. The real value won’t come from models that remember, but from those that can reason through new situations and spot patterns that haven’t happened yet.

• The classic 60/40 portfolio isn’t as reliable as it once was, especially with stocks and bonds often moving together during times of stress. With inflation, rising debt, and global uncertainty, it may be time to rethink diversification and consider adding liquid alternatives that respond differently.

• The way factors are combined can influence results. Some strategies integrate multiple factors within a single portfolio, while others separate them. Each approach has its own strengths and can highlight different types of opportunities.

• The next 10 years probably won’t be about just one market leading the way. As U.S. stock returns slow down, international and emerging markets are starting to look more appealing. They offer a mix of solid growth potential, reasonable prices, and reliable dividend payouts, making them a smart place to look for balance and opportunity.

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Actionable Insights

• Most markets and styles lagged US equities not because of weak earnings alone, but because valuations didn’t follow. With many now trading at a discount, this could be a timely opportunity to increase exposure to regions and styles priced well below US markets.

• Headline inflation looks calm, but with essentials rising faster than wants and data quality slipping, it’s important to stay cautious on rate-sensitive assets.

• Regulatory changes are fueling innovation in the active ETF space. Investors are piling in due to the flexible, hands-on strategy.

• Despite growing deficits, global investors still see U.S. debt as the safest asset because of the dollar’s dominance, U.S. growth, and the Fed’s reliability.

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Actionable Insights

• You can make a slightly higher pre-tax yield than equivalent Treasury bills at a similar risk profile using a box spread. Depending on your tax situation, it can leave you with a meaningfully better after-tax return.

• Most investors overlook the hedging premium when evaluating international bonds. The 10-year Japanese bond yield is under 2% in the local currency, but after adjusting for currency hedging, the total yield jumps above 5%.

• Apple released a paper that argued that Large Language Models only have an illusion of thinking and no actual reasoning.

• Manager selection is vital in realizing the “market-beating” returns touted by alternative asset classes like Private Equity.

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Hi there,

Welcome to the first edition of Market Sentiment Pro. This is aimed at portfolio managers, investment advisors, and serious investors who require and understand in-depth insights into asset allocation.

Our job is simple — to make your job easier. Our team combs through hundreds of academic and institutional reports every week. With MS Pro, we seek to simplify this into clear, concise, and actionable insights. You can spend less time trawling through reports and more time on your main work!

Enjoy our first edition for free :)

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Actionable Insights

• Even the best long-term investments suffer deep drawdowns. However, it’s possible to capture outsized returns by identifying strong companies based on their financial strength, unit economics, and management clarity.

• In the last three decades, nearly 80% of the U.S. stock market outperformance over other developed markets was driven by U.S. stocks getting more expensive over their EAFE counterparts.

• While AI has improved dramatically, it still lags behind on quantitative tasks. ChatGPT tends to be over-optimistic and sycophantic when it comes to financial backtests.

• For the U.S. GDP growth, the next decade will hinge on whether AI-driven productivity can offset the drag of rising U.S. debt and aging demographics.

Even god would get fired as an active investor

The toughest aspect of being a long-term investor is that no matter how good you are, drawdowns are inevitable. Charlie Munger, who returned a 20% CAGR for his fund from 1962 to 1975, experienced a 53% drawdown in the two years ending in 1974. Companies are no different — Nvidia had a 65% drawdown just 3 years back, Nike is now down 70% from its top, and Amazon shares dropped 95% during the dot-com bubble.

While drawdowns are inevitable, investing in those companies during these drawdowns can provide exceptional returns. Michael Mauboussin of Morgan Stanley analysed more than 6,500 companies from 1985 to 2024 and found that the larger the percentage drop in the stock, the higher its eventual bounceback.

The funny thing is that even if you had a crystal ball and knew which stocks would perform the best over the next 5 or 10 years, a portfolio built using these would still have massive drawdowns.

An investor who had the perfect foresight to create a portfolio of the stocks with the highest returns in the next five years would still see substantial drawdowns along the way. Indeed, one five-year stretch of the foresight portfolio had a 76 percent drawdown.

This underscores how hard it is for professionals to manage through drawdowns.

Take a look at the drawdowns of the best-performing companies over the past 4 decades. Even a perfect portfolio will test the resolve of those who own it over the long run.

On the other hand, it’s not all roses and sunshine while “buying the dip”. There are always companies that never return to their previous highs.

The data also reveal that the further a stock falls from its peak, the lower its probability of ever again attaining its past apex. Only about one in six stocks that decline 95-100 percent ever get back to their prior peak, while four in five in the 0-50 percent drawdown group do so.

Analysis of the peak recovery from maximum drawdown, expressed as a percent of par, shows that a majority of companies that have drawdowns of 80 percent or more never get back to par.

While no one can buy at the exact bottom, Mauboussin gives us ways to identify potential winners.

• Are the fundamental issues with the company cyclical or secular?

• Is the unit economics profitable?

• How significant is the capital investment risk?

• How strong are the company’s financials?

• Is the management clear about the challenges?

Source: Drawdowns and Recoveries, Consilient Observer (May’25)

Are we expecting too much from the U.S. Market?

Over the last 35 years, the U.S. market has outperformed other developed global markets by a whopping 4.7% per annum.

But,

Antti Llmanen and Thomas Maloney at AQR Capital did the math. Out of the 4.7% per annum outperformance, EPS growth only gave 1.1% (~23%). The rest was driven by rising valuation.

Since 1990, the vast majority of the US’s outperformance versus the MSCI EAFE Index (currency hedged) of a whopping +4.6% per year, was due to changes in valuations.

The culprit: In 1990, US equity valuations (using Shiller CAPE) were about half that of EAFE; at the end of 2022, they were 1.5 times EAFE. Once you control for this tripling of relative valuations, the 4.6% return advantage falls to a statistically insignificant 1.2%.

In other words, the US victory over EAFE for the last three decades—for most investors’ entire professional careers—came overwhelmingly from the US market simply getting more expensive than EAFE. — AQR Research

This is one of the reasons we are seeing increased volatility in the market. On the day of the tariff announcement, close to $2 trillion was wiped out in one day. While we have bounced back, the relative valuation of the U.S. market is now so high that even a small catalyst can cause significant pain.

Source:

1. Exceptional Expectations: U.S. vs. Non-U.S. Equities, AQR Research (May’25)

2. International Diversification: Still Not Crazy after All These Years, AQR Research (May’23)

Is AI now advanced enough to be a quantitative analyst?

The straight answer is no. But the why is fascinating.

Analysts at Quantpedia recently put together their findings on trying to use ChatGPT as a quantitative analyst. While the model appears capable enough to process data and produce a believable backtest at first glance, issues become apparent once you start digging in.

• Data corruption — Although the model could not retrieve simple data from the internet, it exacerbated the issues by corrupting the data uploaded into it. The team had to frequently reupload the same datasets and had to constantly check whether ChatGPT was hallucinating any new data points.

• Hallucination — ChatGPT claimed the performance of the model it backtested had an annualized return of 8.27%. When the team manually backtested it with the same logic, the actual returns were only 1.74%. The funny thing was that they could not identify why and where ChatGPT made the mistake.

After uploading the data into the model a second time, the results it produced matched our own. How the ChatGPT calculated better ratios in the first time? And why were they different? We have no idea.

• Confidently incorrect — The model overpromises on the chat but underdelivers on the actual code. It promises a strategy built using three underlying metrics, but ultimately will only have two in the code.

While the AI models have certainly improved over the past 2 years, generating a reliable and repeatable backtest seems years away.

It’s still a chatbot, not a data analyst, and the chatbot’s primary focus is to make you happy with the “chatting.” What does it mean? It tends to be over-optimistic and sycophantic – it doesn’t “think”, it answers questions and tries to make you willing to continue in the conversation.

A lot of the time, ChatGPT presented its ideas or analysis and made extremely naive mistakes in it; however, it presented results as the best strategy/idea ever in existence.

Source: Can We Finally Use ChatGPT as a Quantitative Analyst?, Quantpedia (May’25)

Everything now hinges on AI

Take a look at the chart below:

The Congressional Budget Office projects that by 2040, the U.S. Debt will balloon to 170% of its GDP. The next decade will be a tug-of-war between AI-driven productivity growth and structural deficits resulting from an aging society.

While AI is still not good enough to be a quantitative analyst, it excels at certain tasks like simple automation, customer support, and translation. If AI is as transformational as investors are expecting it to be, then AI will create significant time savings, and the resulting productivity boost will drive GDP growth.

However, if AI falls short, the discussion will then focus on deficits and rising U.S. debt. The stock market valuation will not only be affected by the low growth but also by the rising interest rates to counter the inevitable inflation.

For what it’s worth, Vanguard projects that the former has a higher chance based on their Megatrends model.

Source: AI, demographics, and the U.S. economy, Vanguard Research | June’24

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