Whenever the stock market begins to correct from a position that exhibits what John Hussman calls the "overvalued, overbought and over-bullish" syndrome, it is worth studying the reaction of market participants to the decline. Both anecdotal sentiment observations and quantitative sentiment studies are helpful in this respect. Given that the pattern we have recently discussed, as well as the seasonal mid-term election pattern are getting some exposure lately, the probability that a different pattern will actually evolve is rising. Per experience, widely known pattern similarities tend not to continue once awareness of them increases beyond a certain threshold (admittedly it is not knowable where that threshold is). One must therefore consider alternative outcomes as well.
However, we were struck by the preponderance of reports in the financial press that seemed to almost exclusively stress the opportunity the recent sell-off is supposed to represent, while downplaying the risks. The mainstream financial press always has a slightly optimistic slant on things, but previous declines of similar size and speed have created a lot more apprehension as we recall (the last one was in late 2012 on occasion of the budget debate that ended with the 'sequester'). Here are a few examples of what is published these days:
"Market's 19th Breakdown Sees Bulls Unmoved as Trillions Lost". As a friend pointed out to us, there is ironically an old Rolling Stones song called "The 19th nervous breakdown" - released in 1966, just as the valuation and real term peak of a previous major bull market was reached. There is little point in repeating all the assertions made in the article - let us just note that the most bearish comment allows that 'we may have to go a little bit lower'. All the fund managers interviewed agree it's a 'buying opportunity'. We are not sure what they mean by that - are those who have not bought so far going to buy now? If so, why?
JP Morgan's Tom Lee even avers that "the sell-off has created the best discounts in years". How's that for absurd hyperbole? The market is back to where is was in freaking November! Not some distant November many years ago, but the last one.
Remarkable also the reported reaction of investors in junk bonds to the recent flaring up of the EM crisis - they apparently think it is a good time to 'double down': "Contagion Rejected as Biggest Bond Buyers Double Down on Junk" blares Bloomberg. One of the themes of the article is that investors were allegedly 'burned before' when reducing their exposure to risk. This kind of language alone would make us nervous. How can one be 'burned' by not taking risks? Granted, one may miss an opportunity, but opportunities are as numerous as grains of sand on the beach. New ones come along all the time. Many of the arguments made about junk bonds in the above linked article are-- to our mind-- a sign that one should run, not walk, from this asset class. Not only have credit spreads and yields reached record lows when the junk bond euphoria peaked in 2013, 'expected defaults' are at an all time low as well. Whenever such conditions pertained before, it meant only one thing: the market was at best on borrowed time.
Finally, we would be remiss not to mention the one headline that really had us laughing out loud: "Goldman to Fidelity Call for Calm After Global Stock Wipeout". Reading this headline one would normally be inclined to think that the market has just experienced the financial equivalent of an asteroid strike, not a mere five percent pullback. That's right - the S&P 500 is down a whole five percent from its peak. We need 'calls for calm' for that? A five percent pullback is considered a 'wipe-out'? They may be tempting fate with that one.
Of course, the content of the article differs in no way from all the others - 'things are getting cheap' as one adviser remarks. To believe in imminent resumption of the rally is the 'contrarian' stance (seriously). A few quotes from the article are worth pondering:
"Twenty-one strategists tracked by Bloomberg predict the S&P 500 will reach 1,956 this year, on average, representing an 11 percent increase from its level now."
That may seem a fairly modest target, but it isn't really in a historical context - especially considering it is the average expectation.
"If you look back at what happened in 2011, 2008, this correction is simply one of thousands. So if you speak with dealers, speak with other investors, this isn't a feeling of panic."
That is precisely the problem. It means there is still way too much complacency. Of course the stock market rises about 66.5% of the time, so most pullbacks are indeed only short term corrections. Let us not forget though that not only has the market risen by 160% from its lows of five years ago (at which point there was nary a bull in sight), but the bullish consensus has broken records in a number of measures in late 2013. That is what makes the current pullback qualitatively different from those of e.g. 2011 or 2012.
"The plain fact is that very low domestic interest rates for investors holding the vast majority of global financial assets should continue to pull money away from fixed income and towards equities."
As a group, speculators recently (right at the turn of the year) held the largest net short position in 10 year note futures in more than 8 years, so this is not exactly news - in fact, it is the consensus. This brings us to a little noticed event. At the end of last year, which the stock market closed out at a smidgen off a new record high (including a new high for the move in Japan's Nikkei), TLT (an ETF representing long term bonds of 20 years + maturity) put in a subtle divergence by making a higher low:
Right at the end of the year, TLT diverged by putting in a higher low. Note that this coincided on the dot with the combined speculator net short position in 10 year note futures reaching the highest level since 2005.
A few more quotes - here is the by far most bearish one, by a fund manager from Australia:
"Markets are vulnerable to a further correction," Schroeders said by phone on Feb. 4. "The pullback could surprise some people. Perhaps the downside will be a little bit more than people think."
That shouldn't be a problem though - since it will merely mean a better buying opportunity. Not all Australians are as darkly bearish as the fellow quoted above(i.e., expecting 'perhaps a little bit more downside'):
"Nader Naeimi, who helps oversee $131 billion as a Sydney-based money manager at AMP Capital Investors, says people bailing now may regret it.
"Some investors are schizophrenic," Naeimi said in a phone interview. "You have started to see fear back in the market which you hadn't seen for some time. This is good from a contrarian perspective, to remove some froth from the market, reduce complacency and gives me a buying opportunity."
If it is a 'buying opportunity' from his perspective, then we assume he's not 'all in' just yet, but we would take issue with the notion that there is any 'fear' in the market. As you will see further below, there are certainly no signs of fear at present. That may of course change if the correction becomes deeper, and depending on how pronounced an increase in bearish sentiment there is, the situation may become more akin to the one Naeimi thinks he is seeing right now. Conversely, if the market fails to correct further and immediately resumes its climb, we wonder how much bigger the bullish consensus can possibly become (we have seen a number of astonishing records in positioning indicators and survey data late last year).
Quantitative Sentiment and Positioning Measures
One really shouldn't expect a 5% correction to create much excitement (although it looks a little worse in the DJIA - due the stronger relative performance of the NDX, the SPX has held up better). However, the recent correction was quite swift, widely unexpected (as evidenced by the mutual fund cash-to-assets ratio sitting just 10 basis points above an all time low and margin debt reaching a new all time high, among other things) and has been accompanied by a mini-currency crisis in several emerging markets. Moreover, some evidence of economic weakness has emerged and the Fed has embarked on a tightening of its monetary policy (however slight the tightening moves may be so far).
Lastly, money supply growth keeps slowing - especially in the euro area, but U.S. money supply growth is slowing down as well. Normally there is a considerable lag between a slowdown in money supply growth and a decline in asset prices, and one would therefore normally assume the correction to be a mere warning shot. However, there can be no certainty with regard to the lag time - it may be shorter than last time (because the economy is weaker). The SPX has just bounced from its 150 day moving average and is short term oversold (note that it would be quite negative if the bounce fails immediately and it keeps declining in spite of oversold conditions).
The damage in the SPX is still small and the 150 day ma has provided support on Wednesday.
Below we show a few positioning and survey data - this is obviously just a small slice of the universe of such indicators (we show mainly different ones than on occasion of the last sentiment update), but it is nevertheless representative of the overall picture.
The dollar value of the net commercial hedger position in all stock index futures combined (inverted scale). This is roughly the inverse of the speculator net position (unadjusted for spreads). It has come in a little bit, but is far from reflecting 'fear' on the part of speculators. As an aside: small speculators 'bought the dip' last week, expanding their net long exposure by about $3 bn., or roughly 15%.
This index measures the ratio of newly opened bullish vs. newly opened bearish options positions across all options exchanges (i.e., it is not a mere call-put ratio, but includes e.g. put and call writing as well). No fear visible here either.
The ISE call-put ratio - what is remarkable here (which is why we included it) is that the dip buying has already begun.
This chart shows the Consensus Inc. survey of bullish opinion. It tends to be far less volatile than e.g. the AAII survey, so there are fewer whipsaws. Neither very low nor very high readings translate into immediate buy or sell signals. What is remarkable is how little reaction there has been recently compared to previous corrections.
Lastly, here is the Investors Intelligence survey of newsletter writers, which we have previously commented on (mainly to show the difference between the period 2000-today with past secular bear market periods). What is remarkable here is not only that a 17 year high in the bull-bear ratio was recently recorded, but that bears seem extraordinarily timid in view of the correction. We would have expected the percentage of bears to expand a bit from its recent string of multi-year lows, but that hasn't happened.
In light of the Fed expanding the true broad money supply by almost $1 trillion in the course of 'QE inf' so far, the market has been remarkably resilient to warnings from the sentiment and positioning front. However, this is not the first time this has happened. In the run-up to the March 2000 blow-off top in the Nasdaq index, there was also an extended period during which the market defied similar warning signals (and the Fed was pumping furiously as well, in order to avert the imagined dangers of the year 2000 computer date changeover hoax).
In hindsight it became evident that the extended period of the market ignoring these warnings only led to an all the more painful and intense denouement subsequently. There is no obvious reason why this time should be different, even though it is much too early to state that the party is over (it might be, but since the top can by definition only happen once, more evidence is definitely required). All we can state with confidence is that its shelf life is becoming shorter. Could there be a final, parabolic blow-off move after the current correction, as this observer suspects? Obviously we cannot rule it out, but the air would be getting even thinner in that case, and we are beginning to wonder where the limit is supposed to be. 10% bears in the II survey? 5%? Even bigger records in the Rydex ratio? It seems to us that speculative enthusiasm is unlikely to become much more intense than this.
Charts by: StockCharts, Sentimentrader, Decisionpoint