Market Rally: Why So Much Pessimism?

While we all like to think of ourselves as rational beings, making decisions based on sound judgment, the truth of the matter is much more unsettling. We are, for the most part, rather peculiar creatures, prone to irrational and emotional biases. What makes this even more disturbing is that the edifice of our economic and financial system is built on the foundation of a rational, utility maximizing individual.

The most recent sentiment overview shows an amazing turn of events. Even as the stock market has gone on to rise almost 60% from its dark depth 8 months ago, a moderate correction was enough to plunge the majority of retail investors into a new state of capitulation.

Even more curious, instead of investing more as the stock market recovered, which is the norm, the US retail investor has completely given up on equities. Here is an updated chart which I originally shared two months ago (Equity Mutual Fund Outflows):

If anything, the exodus of US retail investors (mutual fund owners) has intensified. The data for the full month of September shows redemptions of almost $13 billion - the most since February, just before the spring rally started. And to make it even more bizarre, the frenzy of bond buying is getting even more frenetic with net purchases of $55 billion (in September).

The data for the latest data (3 weeks in October shown in darker colors) promises a continuation of the same trend, if not a new record. So far, October had net equity redemptions of $11.5 billion.

Almost the same can be seen from insiders trading activity. These more ‘in the know’ individuals have continued to sell shares of their company’s stock almost as fast as they could. While there are many reasons for an insider to sell (diversification, divorce, etc.) the fact that we aren’t seeing an uptick in purchases is telling.

So why is there so much pessimism around this latest stock market rally?

Loss Aversion
A concept from behavioural finance offers a possible explanation for the bizarre fund flows pattern, bearish investor sentiment and insider selling. “Loss aversion” is a concept from prospect theory which explains that people prefer to avoid losing, rather than take a proportional risk to receive a gain.

Think of it this way. Given an event which triggers either a loss or a gain of the same amount, for some strange reason, we prefer to avoid a loss, rather than receive a gain. In other words, we prefer to keep what we have (not lose some or all of it), rather than add to what we already have. For most people, losing is much more painful than gaining is pleasurable.

Having experienced such scorching losses, the average US investor has a very clear idea of the kind of risks that exist in the equity market. They are intimately acquainted with them - most would say too intimately by now. So the possibility of further losses is also very real. In contrast, fixed income offers a cool balm - the perception of less risk and slow, steady returns.

A Real Bull Market
The retail investors and insiders are not showing up at the party, there is an unmistakable ‘wall of worry’ and prices have an uncanny way of climbing higher, against all seeming logic. It could very well be that Wall Street has thrown a party. That’s what one of the most respected technical analysts thinks.

Paul Desmond, the 2009 Technical Analyst of the Year (awarded by Technical Analyst magazine in the UK), thought the rise off the March lows to be merely a bear market counter rally and scoffed at the idea of a new bull move as late as June: This is No Bull Market. But then surprisingly, Lowry Research turned bullish in in August: Intermediate Buy Signal.

While Lowry missed a good portion of the stock market gains from the spring bottom, you won’t hear many of their clients complaining as they were saved untold anguish and loss by being told to exit the market in July 2007 - three months before the bear market top.

Now, Desmond’s firm believes that we are in the midst of a bull market that will last another 3 years. He bases this on Lowry’s proprietary analysis of demand and supply in the stock market as well as the four year stock market cycle.

The Importance of Being High
If you are skittish, Desmond suggests you keep an eye on the new 52 week high list. Since major market tops are made slowly, as leadership is lost, the number of new highs tapers off months before indexes themselves makes a top. According to studies of market history, if you find that 11% or less of the NYSE shares are making new 52 week highs, watch out! But that sort of pattern is not evident right now.

Last month, on the NYSE there was an average of 149 stocks a day reaching new highs. In October, that average was 173 daily new highs. Based on this strong showing, Desmond says, “The patterns we see here are very similar to those that preceded previous major market bottoms”.

Even if there is a party in full swing on Wall Street, in the short term, it is prudent to be cautious. The percentage of S&P 500 constituent stocks trading above their 10 day moving average was 73% on Friday. And with a strong showing on Monday that could jump to mid 80’s, leaving little overhead room for further advancement the rest of this week.

But then again, Paul Desmond says that these sort of breadth rules do not apply in the early stages of a multi-year bull market as “overbought” tends to be the norm.

Comments

[Mike from NYC:]

Why the pessimism? Because no one believes anything anymore and figure it's all rigged by the big players.

How many times do you need to get burned since 2000 to show to you that nothing is as it seems? There's very little transparency.

Nov 10 11:42 AM

[Northern Da...:]

Once again, great topic Babak!

From what I understand, not only are funds flowing out of equities and into bonds, they're flowing out of American based equities and into foreign stock markets. I'm guessing that the reason for it is that this rally has come on the back of decreasing volume right from the second week back in March. And the volume of this latest rally of 6 straight up days has come on very noticeable shrinking volume every single day. There's no conviction. I honestly believe that the only source of funds propping up this plastic rally is GS, et al.

I recently saw some charts of the S&P priced in Asian and European currencies and what it showed was very telling if not downright shocking. It showed that since June, when the S&P is priced in any currency except USD, the market has been flat. What that's saying is that all advances June have been purely and unarguably currency driven. The market has gone up simply because the dollar is crashing. The investors of the world are beginning to see the situation for what it really is. At this point in time, I can't envision "anything" that's going to bring them back.

I fear that what we're going to see in the very near future is the dollar and equities falling at the same time. The worst of all worlds. The only caveat to that, is that I wouldn't put it past the FED to pull off the phoniest and blackest surprise of all, by either suddenly and unexpectedly raising rates, or by simple rhetoric alone, causing a spike in the dollar. With 98% bearish sentiment, it wouldn't take much. And the stock markets wouldn't like that either. In fact, it's come to the point in time that the markets don't like a weakening dollar anymore, and they don't like a strengthening dollar at all. In my view, the table is set.


.

Nov 10 11:54 AM

[chris coonan:]

Why? Well there are about 64,000 reasons, and they are all covered on Seeking Alpha, a good place to read up on what is underneath the big stack of matresses....not even a pea....

Nov 10 12:19 PM

[MattZN:]

I certainly agree with your assessment of the market when viewed through the lens of other major currencies. We aren't in a bull market from their point of view.

Basically this is the cost of the Fed holding interest rates artificially low. This is also why Energy and other commodity stocks have been so insanely hot for the last 12 months, and why large-cap stocks (which tend to have significant international exposure) have outperformed. IBM being an example of the latter.

How low is the Fed willing to let the dollar go before they are forced to begin raising interest rates? That's the question now. Honestly, I don't know why people are pushing into bonds, they are just as dangerous as equities (if not more so) right now.

-Matt

Nov 10 12:44 PM

[bartpr:]

chasing bonds is frought with risk. the monetary base created by the fed is incredible. once it is converted into money supply outstanding in the form of loans inflation is back and bonds are toast.

also, the fed has bought a ton of treasuries because of the lack of buyers. without the fed, interest rates would have climbed.

new highs and lows should be measured from the mar bottom and not a years back. it presents a better picture of buyers and sellers.

Nov 10 01:27 PM

[bob adamson:]

Thank you, Babak, for raising and discussing this anomaly in current market sentiment; the general pessimism despite the spectacular stock market gains since March. Put another way, try to visualize any eight month period in living memory except that since March and ask what the general mood would be if the S&P 500 had increased from 666 to 1100. The general mood would be extremely buoyant and the market consequently probably overbought. What is going on now, therefore?

Arguably the answer is that the back-story we all focus on now is not the eight month dramatic recovery of stock market prices but rather the traumatic drops preceding March of this year (particularly the plunge of October 2008). Those that follow technical analysis have their own ways of charting these unique trends in market sentiment.

Nov 10 04:06 PM

[Northern Da...:]

On Nov 10 01:27 PM bartpr wrote:

> chasing bonds is frought with risk. the monetary base created by the fed is incredible. once it is converted into money supply outstanding in the form of loans inflation is back and bonds are toast.

also, the fed has bought a ton of treasuries because of the lack of buyers. without the fed, interest rates would have climbed. <


bartpr, here's a link to an insta posted just today that goes into a detailed discussion of bonds, including questions about why they haven't rallied along with equities and suggesting it's because even at these lower yields, they're still better than a shaky stock market. It's an interesting discussion if you're interested:

seekingalpha.com/insta...

Nov 10 07:57 PM

[untrusting ...:]

Bob,
The answer has too do with the fact that virtually nothing in the market price action since probably about June/09 makes much sense or compares rationally with previous recessionary markets.

As just a few of examples consider:
1) late day trading spikes - if one checks/follows the daily trading charts, it is obvious that there were literally dozens and dozens of days when the market was selling off, and then magically late in the day, usually in the last hour a complete reversal and virtual parabolic spike kept the rally going instead of corrections being allowed to happen.
2) Trading domination by a handful of larger prop desks and traders - many reports have shown that as much as 50-70% of the entire trading volume has been done by less than 2% of the market participants.
3) Options - many authors have shown very large late day options purchases, particularily on the major indexes. Again late day spikes and large purchases that have effectively turned a substantial daily correction into the continuation of the uptrend.
4) Trading records - for example Goldman has winning trading records in excess of 90% for several quarters now. Never been done in stock market history before, and statistically and mathematically almost an impossibility.
5) Many abnormal other factors showing up such as: near record high corporate insider selling, large amounts of retail money exiting stock mutual funds and moving to bonds (20:1 ratio), low volume on ramped market rises vs. much higher volume on sell-offs.

In short, it is quite obvious to many market observers that there are some very very strange and abnormal factors behind an irrational and almost straight up move in equity markets since March/09.

Small investors and market observers are a lot more astute these days than they were even back in 2000-2003. Many are starting to understand how "rigged" the markets have become in favor a tiny minority of the big players and big traders. Thus why would retail investors and even others want to participate, at this point, in an equities market that is substantially overvalued by any historic metrics and exhibits many strange factors behind the rally uptrend.


On Nov 10 04:06 PM bob adamson wrote:

> Thank you, Babak, for raising and discussing this anomaly in current
> market sentiment; the general pessimism despite the spectacular stock
> market gains since March. Put another way, try to visualize any eight
> month period in living memory except that since March and ask what
> the general mood would be if the S&amp;P 500 had increased from 666
> to 1100. The general mood would be extremely buoyant and the market
> consequently probably overbought. What is going on now, therefore?
>
>
> Arguably the answer is that the back-story we all focus on now is
> not the eight month dramatic recovery of stock market prices but
> rather the traumatic drops preceding March of this year (particularly
> the plunge of October 2008). Those that follow technical analysis
> have their own ways of charting these unique trends in market sentiment.

Nov 10 09:09 PM

[thiazole:]

^^Here comes the conspiracy theories - better put on your aluminum hats.

Babak, you state, "Last month, on the NYSE there was an average of 149 stocks a day reaching new highs. In October, that average was 173 daily new highs."

I'm trying to get an idea of the direction of that trend, but "last month" was October. So what did you mean by "last month".

Nov 12 10:43 AM