Sentiment is a contrarian indicator. Strong returns usually follow periods where sentiment is currently poor and beginning to improve. Conversely, weak returns tend to follow periods where sentiment has been euphoric and has begun to deteriorate.
We are seeing early signs of euphoria. This doesn’t mean that a bear market is imminent. Euphoric conditions can persist for a while. Meanwhile, other indicators, such as the uptrend in the S&P 500 and other indices remain positive. The actions of the US Federal Reserve are also supporting equity markets.
What it does mean is that now probably isn’t the time to be taking a lot of risk. We’ve implemented this view in our portfolio by:
· Letting our cash allocation slowly/gradually drift upwards as stocks are sold
· Reducing our risk exposures across the portfolio (i.e. tightening our stops)
Our view on US equities remains neutral-to-positive. But we can’t ignore the observation that market’s mood is starting to feel like it did in early-2018.
You may remember that the S&P 500 had a fantastic year in 2017, up 20% (price return, USD unhedged). The market trended upwards for most of the year with the lowest level of volatility on record. Tax cuts saw the S&P 500 surge in anticipation of higher corporate earnings.
The market began 2018 in a euphoric mood, up 7% in January 2018. February was a different story, with the market correcting by more than -10% on skyrocketing volatility.
Sentiment is a “feeling” or a “mood”. But that doesn’t mean that it can’t be measured objectively.
There are lots of different ways to measure investor sentiment. In this post, we’ll consider some examples of the following types of sentiment indicators:
· Investor Positioning and Flows
· Performance of Risk-on vs Risk-off Assets
· Composite Indicators
· President Trump’s Tweets and the news media
I threw the last one in for a bit of fun.
The Put/Call ratio measures investor sentiment by comparing the number of investors purchasing puts ( hedging or expressing a bearish view) versus the number of investors purchasing calls (speculating or expressing a bullish view).
A ratio above one means that the bears are dominant. Conversely, the lower the ratio, the more bullish investor sentiment.
The Put/Call ratio is currently 0.63, which is the lowest its been since January 2018.
The VIX index is a real-time market index that represents the market's expectation of 30-day forward-looking volatility. The VIX had been in an uptrend (i.e. higher lows shown by the red line) from January 2018 through to November 2018.
The VIX is currently at 12.29%, which is one standard deviation below its 60-day moving average (red bands).
Low levels of volatility and the dominance of speculators vs hedgers indicate investor complacency.
Investor Positioning and Flows
Rydex (Guggenheim) offer a suite of geared long (bull) and short (bear) mutual funds. The chart below shows the ratio of assets invested in bear market funds vs bull market funds. A low ratio means that the bulls dominate bears.
The Rydex Bear/Bull ratio was briefly in the euphoria zone in early-December. Its currently 0.044, almost one standard deviation below the 100-day moving average.
Hedge funds have recently increased their estimated exposure to stocks from almost minus -30% to more than +50% in the last few months (chart courtesy of Sentiment Trader)
Hedge Funds haven’t been this bullish since early 2018. Historically, returns on the S&P 500 are lower when hedge funds are allocated above 50%.
TD Ameritrade publish the Investor Moment Index. The index measures sentiment by measuring the aggregated trading activity of thousands of individual account holders.
As of the end of November, the index reached 5.17 as investors were net buyers of stocks during the month. Investors also seem to be switching from Exchange Traded Funds (ETFs) that invest in defensive assets for more aggressive ETFs (chart courtesy of Sentiment Trader).
Investors of all types are becoming more aggressive and moving into stocks.
The American Association of Individual Investors (AAII) surveys its members each week. Members are asked if they’re bearish, bullish or neutral on the market. The chart below compares the percentage of respondents that are bullish and bearish (i.e. it ignores neutral responses).
Individual investors were extremely bullish in early-November. Their optimism moderated as the month progressed. The December rally has seen the Bulls minus bears score once again reach over-optimism (one standard deviation above the 100-day moving average). The National Association of Active Investment Managers surveys approximately 200 Registered Investment Advisors in the USA. The survey measures the equity allocation that these advisors recommend to their clients.
Advisors are optimistic but not euphoric. The current equity allocation is 78.71% versus a 100-day moving average of 71.17%.
The Investors Intelligence survey shows bulls outnumbering bears by almost 3.5-to-1. Historically, readings above 3:1 indicate over-optimism (chart courtesy of Yardeni Research).
The next three charts come from the Bank of America Fund Manager Survey (courtesy of ZeroHedge). The asset managers that respond to this survey are responsible for managing approximately US $745 billion in assets.
Cash held by asset managers in the survey is at a 6-year low.
The number of survey respondents stating that they are overweight cash is 18%, the lowest since November 2015.
31% of survey respondents are over-weight stocks, a 10% jump month-on-month and the highest level in over a year.
Most survey measures (with the exception of NAAIM) are showing signs of investor euphoria. The low levels of cash on the sidelines also mean that their future buying power (i.e. “dry powder”) is reduced.
Performance of Risk-on vs Risk-off Assets
The charts below show the ICE BofAML US Corporate BBB Option-Adjusted Spread. BBB bonds are the lowest-ranked, investment-grade corporate bonds.
The spread between BBBs and US Treasuries of a similar maturity is currently a low 1.34% (16/12/2019). To put this into perspective, the BBB spread got as low as 1.15% during the market euphoria of early 2018.
The S&P Low Volatility Index (SPLVI in blue) has gone sideways since early-September, while the S&P 500 index (black) has zoomed higher.
The rolling 12-month performance of defensive stocks vs the S&P 500 is more than -4%, the worst its been over the last 12 months.
Tight credit spreads show that investors are willing to settle for lower risk-adjusted returns. In other words, they are less concerned about default risk (i.e. they are optimistic. The performance of defensive stocks versus the market clearly illustrates the shift from defence to offence.
There are also indicators-of-indicators, i.e. measures of sentiment that combine several different sentiment measures to create a single sentiment measure. An example of this is the CNN Fear and Greed Index.
The index score is currently 85 out of 100 which puts it in the “Extreme Greed” zone.
President Trump’s Tweets
Here’s a chart showing the frequency of President Donald Trump’s stock market tweets (green) and press articles about a stock market “melt up” (chart courtesy of Sentiment Trader).