Market Insights: Sentiment and market tops

Sentiment and market tops

We have been astonished at the level of pessimism that has been expressed in widely followed sentiment surveys of late, not to mention a whole host of other indicators and data that we typically see at market bottoms, not market tops.  With the S&P500 only a couple percent shy of its all-time high, we feel more confident that this is indicating we are more likely to see new highs than to retreat back down to the lows we witnessed earlier this year.  In the last couple weeks, we have compiled a few interesting charts that we want to share to illustrate this point.  We feel this bodes well, in conjunction, with our fundamentally positive thesis on markets discussed both here, here and here from prior posts.

We will start with the American Association of Individual Investors (AAII) bullish sentiment indicator.  As shown in the chart below, for the week ending May 20, 2016, it hit a level of 17.75% which was the lowest level of bullish sentiment in over a decade!  If you are wondering how that is possible even when the depths of the Great Recession are in that data set, we don't blame you.  The primary reason is that the 'neutral' camp is so high right now, whereas back then the 'bearish' camp was at an extreme.  This current bullish reading, however, is lower than what we saw recently in January when the market was 10%-15% lower.  The bottom line here is that a bullish sentiment this low is definitely not a characteristic of a market top.  Bullish sentiment readings below 20 are very rare, and are followed on average by 6-month returns of 11.2% for the S&P 500. 

Source: Bespoke Investment Group, American Association of Individual Investors 

Next up is the mass outflow of equities in the U.S.  Bank of America Merrill Lynch's Chief Investment Strategist, Michael Harnett, has characterized this as an "equity exodus".  The cumulative outflow from equity funds over the past five weeks was $44 Billion as of mid-May, which he noted was the largest redemption over a 5-week period since August 2011.  The glaring difference between then and now is that was right at an intermediate-term bottom in the equity markets where we subsequently saw very strong gains.  We also saw a comment from Richard Bernstein, CEO of a respected investment management firm that oversees over US$3 Billion, that the "2015/2016 net outflows from equity funds + equity ETFs are already bigger than 2008/9".  This is very surprising considering it is only May.  Again, this type of data is more typical of a market bottom rather than a market top.

Moving on to Initial Public Offering (IPO) activity, for the January to April period, we have just observed the third lowest level of activity in the last 25 years.  From the chart below, you can see that the two other years that had less activity were 2003 and 2009.  These were the years where recessions ended in the U.S. and were springboards for equity markets.  It is impossible to know if this relationship will occur again today, but it is difficult to ignore that over history, IPOs tend to dry up at market bottoms, not market tops.

 

Source:  FactSet, BofA Merrill Lynch

In addition, we have seen many sources point to the fact that most U.S. fund managers are underinvested against their benchmarks, and will be pressed to push money into the markets if we see new highs in the near future.  If we see capital rotate back out of bonds and into equities, it could push that momentum a long way.

Lastly, we wanted to show the chart of the PHLX Semiconductor Index.  This index is comprised of companies in the U.S. that are developers, manufacturers and marketers of digital and analog chips. The reason for commenting on this is that the semiconductor industry is widely regarded as a leading indicator of U.S. economic activity.  As a result, this index tends to lead advances in the broad equity market such as the S&P500.  As you can see, it recently moved to a new intermediate-term high this past Friday.

 

Source: Thomson Reuters

As with any data, there is no way to ensure that the future will follow the past, but when we take the weight of evidence of negative sentiment, among others, coupled with what we believe are fundamentally positive drivers in place, it sure feels like the market wants to push to new highs and advance the current cycle.  As we stated in the fall and early this year, our in-house U.S. recession indicator, which never flashed red as markets were in steep corrections, has kept our asset allocation decision making an objective one.  We continue to monitor these leading indicators, and if the weight of evidence suggests a more defensive stance at some point then we will be ready to move in that direction, but for now we remain positive.