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Quick Reversal In Investor Sentiment

  • Written by Syndicated Publisher 1 Comment1 Comment Comments
    February 28, 2014

    As investors headed into the end of December, bullish sentiment was pushing extremes which led me to write a post entitled “Market Bulls Should Consider These Charts” in early January.   A few days later, the markets entered into a two week correction of 6% that sent investors scrambling for the sidelines.  Now, four weeks later with the markets hovering near all-time highs, investors anxiously await Janet Yellen’s Congressional testimony to see if she will potentially “taper the taper” due to slate of weaker economic data as of late.

    A quick look at investor sentiment (both individuals and professionals) shows a quick return to extreme bullishness following the recent selloff.

    AAII-IINV-Bull-Bear-Ratio-022714

    While not at the historic high of 3.46 seen just this past December, which should be concerning enough, the current reading of 2.1 is at levels that have historically been consistent with both short and intermediate term market peaks.

    Another way to look at this data is by subtracting the bearish sentiment from the bullish to get a “net bullish” sentiment reading. This is shown in the next chart.

    AAII-NetBullRatio-022714

    Following the historically high reading in December of 40.75, net bullishness fell to a low of 1.32 in January.  That “bearishness” has now quickly rebounded to 21.1 as of this past week.  Again, as with the first chart, a reading above 20.0 has historically been associated with market tops.

    One interesting data point, however, is found in retail investor fund flows.  While equity inflows have continued to move into the market, bond flows have also turned positive.

    ICI-Equity-Bond-Flows-022714

    While this would suggest that investors are becoming more cautious on equities at this late juncture, there is no evidence that they are rotating out of risk.  Unfortunately, that is generally the case as investors don’t start rotating out of “risk assets” until after a market reversion is already underway.

    The chart of the Volatility Index (VIX) below is another measure of the extreme complacency of investors.  Despite several small corrections along the way in 2013, investors currently have little concern about a significant market correction.  Currently, the 6-month average of the VIX is at levels not seen since the last cyclical bull market run.

    S&P-500-VIX-022714

    Lastly, one of the bigger concerns is simply the current level of price deviation of the S&P 500, and the broader Wilshire 5000, index from its long term moving average. Prices cannot remain extremely deviated from their underlying moving average indefinitely.  Eventually, the price will revert toward the long term mean which is both logical and inevitable. Currently, both of these indices are currently at levels of deviation normally associated with more intermediate term market peaks.

    S&P-500-Wilshire-Dev-36M-022714

    While investors were extremely quick to reverse their “bearish” sentiment in the short term, there are mounting headwinds for the markets in the months ahead.

    1) The Fed is in the ongoing process of extracting liquidity from the financial markets.  All recent commentary from the Federal Reserve indicates that they wish to conclude the current bond buying program by October.

    2) This is a mid-term election year which tends to increase market volatility as the debates and uncertainty around potential policy/leadership changes weigh on investors.

    3) Lastly, the current economic weakness seen as of late is likely more than just the impact of the “weather.”   While many companies will use “the weather” as an excuse for why revenue and/or earnings miss estimates, there is plenty of evidence that the economy is already moving towards a slower growth rate.

    While the financial markets could certainly rise higher from the current momentum, it is worth noting that with both the economic and bull market cycles already extended in duration the likelihood of a reversion has increased.  Such a reversion would likely coincide with the onset of an economic recession.  Given the current decline in the annualized trends of several major economic components from consumption, to manufacturing and imports, the odds are increasing that such a recession could occur within the next 18-24 months.

    However, even with that said, it is important to remember that we are all just “guessing” at what the future might bring.  There are plenty of reasons that the market could lapse into a far bigger correction sooner than the historical evidence would otherwise suggest.  Such an event would not be the first time that an “anomaly” in the data has occurred.

    The inherent problem with the analysis contained within this missive is that it assumes everything remains status quo.  The reality is that some unexpected exogenous shock is likely to come along that causes a more severe reversion as current extensions become more extreme.   This was best summed up by Jeremy Grantham who recently noted:

    My personal guess is that the U.S. market, especially the non-blue chips, will work its way higher, perhaps by 20% to 30% in the next year or, more likely, two years, with the rest of the world including emerging market equities covering even more ground in at least a partial catch-up. And then we will have the third in the series of serious market busts since 1999 and presumably Greenspan, Bernanke, Yellen, et al. will rest happy, for surely they must expect something like this outcome given their experience. And we the people, of course, will get what we deserve. We acclaimed the original perpetrator of this ill-fated plan – Greenspan – to be the great Maestro, in a general orgy of boot licking. His faithful acolyte, Bernanke, was reappointed by a democratic president and generally lauded for doing (I admit) a perfectly serviceable job of rallying the troops in a crash that absolutely would not have occurred without the dangerous experiments in deregulation and no regulation (of the subprime instruments, for example) of his and his predecessor’s policy. At this rate, one day we will praise Yellen (or a similar successor) for helping out adequately in the wreckage of the next utterly unnecessary financial and asset class failure. Deregulation was eventually a disappointment even to Greenspan, shocked at the bad behavior of financial leaders who, incomprehensibly to him, were not even attempting to maximize long-term risk-adjusted profits. Indeed, instead of the ‘price discovery’ so central to modern economic theory we had ‘greed discovery.

    What can go wrong for the market? There is a slow and for me rather sinister slowing down of economic growth, most obviously in Europe but also globally, that could at worst overwhelm even the Fed. The general lack of fiscal stimulus globally and the almost precipitous decline in the U.S. Federal deficit in particular do not help.”

    Images: Flickr (licence attribution)

    About The Author

    Lance Roberts – Host of StreetTalk Live

    After having been in the investing world for more than 25 years from private banking and investment management to private and venture capital; Lance has pretty much “been there and done that” at one point or another. His common sense approach has appealed to audiences for over a decade and continues to grow each and every week.

    Lance is also the Chief Editor of the X-Report, a weekly subscriber based-newsletter that is distributed nationwide. The newsletter covers economic, political and market topics as they relate to the management portfolios. A daily financial blog, audio and video’s also keep members informed of the day’s events and how it impacts your money.

    Lance’s investment strategies and knowledge have been featured on Fox 26, CNBC, Fox Business News and Fox News. He has been quoted by a litany of publications from the Wall Street Journal, Reuters, The Washington Post all the way to TheStreet.com as well as on several of the nation’s biggest financial blogs such as the Pragmatic Capitalist, Zero Hedge and Seeking Alpha.

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