Sentiment Still Supports The Bullish Case

Includes: JCI, SPHQ
by: Clif Droke

Drop in bearish sentiment doesn't mean the market recovery has ended.

Elevated neutral sentiment is keeping the "wall of worry" intact.

Fears over debt, volatility, and global economy also support bull's case.

Much has been made by bearish investors of the recent drop in bearish sentiment in various Wall Street sentiment polls. The bears suggest that the decline in pessimism among the average participant is a sign that the crowd is becoming complacent on the 2 ½-month-old stock market recovery. The implication, of course, is that stocks are becoming vulnerable to a raid by sellers which could provide another sizable decline in the major averages. While this is certainly a possibility given how far equities have rallied since December, in today's report I'll make the case that investor sentiment is - in the aggregate - still very much supportive of a continued market recovery.

Notwithstanding the dull market environment of recent days, sentiment on the U.S.-China trade outlook has supported the elevated levels in the Dow and S&P 500 Index (SPX). It has also helped reduce market choppiness since the last big volatility spike in December. Recently it was reported that both countries are in the final stages of trade negotiations with a final deal possible by the end of this month. As part of the final deal, Beijing is reportedly offering to lower tariffs on U.S. agricultural, chemical, auto and other products. Washington meanwhile is said to be considering removing most, or all, sanctions levied against Chinese products since 2018.

Serving as a check on this optimism, however, is a growing concern that a favorable outcome of the trade dispute may be a classic case of "sell the news." It's believed by some observers that the stock market has already priced in the recent optimism on the trade discussions, thus an announcement of a mutually beneficial trade accord may be treated by many investors as a selling opportunity.

A slew of news articles in the last few days have highlighted this sentiment. Some analysts, like Neil Shearing of Capital Economics, have gone so far as to assert that a trade agreement may not stimulate the global economy as many have anticipated. Shearing also pointed out that the White House apparently wants to include a clause in the final agreement that would reinstate higher tariffs should China's fail to comply. If true, this would mean that uncertainties could continue to linger even after a tariff truce is concluded.

As of this wasn't enough of a worry for investors, there is also the latest news out of China which showed that the country has cut its economic growth targets to a 30-year low. China lowered its growth target for 2019 to between 6% and 6.5%, while acknowledging a slowdown. However, Beijing also announced a stimulus to the tune of billions of dollars in proposed tax cuts and infrastructure spending to help mitigate the effects of the slowdown.

By virtue of the fact that there are enough widespread worries over China and the still-uncertain global trade outlook to merit mainstream news articles, I would argue that this is proof that investors haven't completely embraced the bull yet. Keep in mind that every bull market needs the proverbial "wall of worry" to climb. Worry after all is what keeps short interest levels high, which in turn serves as potential fuel for future rallies. The lingering worries reflected in the above-mentioned articles strongly suggest that the "worry wall" remains firmly intact.

In yet another sign investors are finding new things to worry about, there has been more than a few news articles over the rebound in the high-yield debt market. The latest $10 billion financing of the car battery unit of Johnson Controls International (JCI) has been mentioned as a case in point by many observers that junk bond demand is increasing. The junk bond market this year is off to its best start since 2001, although many observers view this as a sign of potential danger to come.

Indeed, past financial market crises have often been preceded by strong demand for high-yield bonds, followed by a breakdown in the market for "junk" debt. However, to date there is no sign in the high-yield market of any such trouble. Shown here is the BofAML U.S. High Yield Master II Option-Adjusted Spread. This indicator rose to its highest level in years in late 2015-early 2016 during the energy sector crisis. Since then, credit spreads have declined considerably and are now near multi-year lows. This indicates that the market doesn't foresee a crisis brewing anytime soon.

ICE BofAML U.S. High Yield Master II Option-Adjusted Spread Source: St. Louis Fed

As if that weren't enough for investors to worry about, some have even expressed concern over the lack of volatility in recent weeks. Normally rising volatility levels would be a legitimate source of concern for stock market participants. However, dwindling volatility in a market that is characterized by internal strength (i.e. no signs of selling pressure) and a dovish Fed should be considered bullish. Yet the fear that the market is on the precipice of another sell-off is so pronounced right now that even a single day's spike in the CBOE Volatility Index (VIX) is enough to cause alarm in some quarters. An example of this was Monday's 30% move from its intraday lows in the VIX. If even a single day's "whipsaw" type move in VIX is enough to send the bearish alarm bells ringing, I'd say it's safe to conclude that there is still plenty of latent fear to go around. And from a contrarian perspective, that's bullish for the stock market's intermediate-term outlook.

CBOE Volatility Index

Source: BigCharts

One major sign that investors haven't yet been overcome by greed is the large amount of neutral sentiment reflected in many sentiment polls. For instance, the latest sentiment poll conducted by the American Association of Individual Investors (AAII) reveals that while only 20% of its members are bearish, a whopping 38% are currently neutral. This is above the historical average of AAII neutral sentiment. The fact that so many individual investors aren't sure where the market is headed is proof enough that non-commitment is still a factor in this market. This should serve as a protection against a major market decline happening anytime soon.

Another indicator which shows that neutrality reigns supreme among mutual fund traders is the Rydex Funds Nova/Ursa Ratio Sentiment Indicator. This indicator is currently right around the zero level, which shows a near-perfect balance between bullish and bearish bets on the U.S. stock market. At worse, this supports a sideways market trend in the major indices like the SPX. I would argue, however, that this neutral sentiment suggests a preponderance of uncertainty among participants. And when there is uncertainty in a market environment characterized by technical and fundamental strength, the most likely outcome of this uncertainty is higher stock prices. For a bear market doesn't typically begin until most investors have succumbed to the bull by loading up on stocks. There is currently no evidence that the average retail investor is heavily exposed to equities, hence my belief that the neutral sentiment on Wall Street is a confirmation that the bull still lives.

Rydex Funds Nova/Ursa Ratio Sentiment Indicator Source: Market-Harmonics

While there are still concerns among investors over things like debt, volatility, and the global economic outlook, on the U.S. economic front the news has been much more encouraging. On Tuesday, Boston Fed President Eric Rosengren said that his previous concerns that the U.S. economy might overheat "seem somewhat less concerning at this juncture." He further predicted that this year's U.S. growth rate would moderate compared to last year's rate. He added, however, that it would likely remain above the long-term U.S. growth rate. This bit of news should prove comforting to investors since it belies a dovish monetary policy stance on the Fed's part in the coming months.

All in all, there is more than enough evidence to suggest that sentiment among retail investors is leaning more towards worry and uncertainty than euphoria. And as anyone with long experience in the market should know, uncertainty is one of the best protections against a bear market. As previously mentioned, worry and uncertainty keeps short interest levels high and encourages short-covering rallies. This is especially true when the incremental demand for equities - as measured by the short-term rate of change in the cumulative 52-week highs and lows - is rising. As the following graph shows, this is currently the case.

Source: WSJ

On a strategic note, investors should be long the sectors and industries which are showing the most relative strength and solid fundamentals. In particular, investors should be looking at consumer staples, pharmaceuticals, and real estate equities, as well as the tech sector in general. I also recommended that technical traders maintain a long position in a market-tracking ETF, such as the Invesco S&P 500 Quality ETF (SPHQ), of which I'm currently long.

Disclosure: I am/we are long SPHQ, XLE, XLF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.