Co-produced with The Belgian Dentist for The Income Strategist
Stock prices are driven by fundamentals over long periods of time. In the short term, investor sentiment plays a big role. Fundamentals are strong for REITs, and this bodes well for the longer term picture. Investor sentiment for REITs is quite bullish, and this could be a contrarian indicator in the near future. If this price weakness would materialize, it will be a nice buying opportunity offered to you by Mr. Market.
Investor sentiment can be a powerful determinant of security prices, especially in the short run. For example, extremely bullish levels of sentiment often occur after strong market run-ups. But, in many of cases, when valuations reach an extreme and sentiment has run its course, the market tends to reverse course.
When valuation is not at an extreme level, however, which is currently the case with REITs, investor sentiment has a bigger impact on short-term returns than long-term returns. We may have seen the impact of shifts in investor sentiment as news about the trade tariffs has been reported. When the news has been negative, REITs tend to rise when investors position themselves defensively, as well as tactically allocating to sectors not affected by international trade. Meanwhile, the fundamentals of real estate continue to be strong, so long-term prospects seem solid.
So, with valuations reasonable and fundamentals strong, what could investor sentiment be signaling in the short term for REITs?
Canny market watchers have known this for a long time: if you want to know when the market is about to turn, look for investor sentiment to reach one extreme or the other. On March 5, 2009, the AAII survey reached its highest ever levels of bearish sentiment, with 70.3% of the respondents having a negative outlook on the stock market. This was six months after the Lehman Brothers meltdown sent the entire economy into a tailspin, and after the S&P had lost 45 percent. The very next day, the S&P reached its bottom and has been on a 10-year expansion ever since.
It works the other way, too. The AAII survey reached its bullish peak on January 6, 2000, just as the dot-com bubble was cresting. At that point, a full 75 percent of the investors surveyed were optimistic about the future of stocks. That bull market had a little bit longer to run, but it started its decline by September of 2000. We all know what happened next.
Market sentiment - the summation of all expectations for the market as a whole - often directly reflects where the market has been, not where it is going. At its extreme levels, it usually indicates the psyche of many investors who extrapolate trend-chasing bias into their views of the future potential of the market.
When market sentiment is low, it is usually after a prolonged period of stock market declines that cause investors to conclude that the same trend will continue. They don't see the light at the end of the tunnel, so they expect the market will continue to decline as it has been. The same mentality applies to when the stock market has been rising, as is the case today.
However, history shows us that more times than not the market tends to turn around when there is a strong majority leaning one way or the other. By following some of the market sentiment indicators that track how investors are thinking, we might be able to pick out market tops and bottoms.
As difficult – or impossible – as it is to time the market, investor sentiment has successfully been used as a contrarian indicator for the overall market. There are different ways to measure market sentiment, however, including surveys of individual and professional investors, examining trading data such as block trades and short interest, or even by monitoring the trend in cover stories of major publications.
REIT investor sentiment
Unfortunately, there aren’t any investor sentiment gauges specifically for REITs.
We can look at past returns, flows, short interest figures, momentum scores and surveys, but the surveys aren't as comprehensive, nor do they have the historical data that broader market surveys have.
When we look at the past 1-year total return figures of the major asset classes, however, REITs are by far the best performers. Investors susceptible to chasing returns will likely be bullish on REITs, therefore, and we can presume that there is more bullish sentiment towards REITs than for many of the other sectors.
Exhibit 1: 1 year total return
Another good indication of sentiment is fund flows going into and out of specific sectors. I would argue that this metric is even better than a survey because it shows what investors are actually doing with their portfolios, not just what they say they are going to do. For example, I can state in a survey that I am bullish, but not act on it by keeping a large portion of my portfolio in cash. However, if I start allocating that cash into the market, and specifically, into certain sectors, then that is a good indication that I am bullish on those sectors.
When we look at sector flows, there is a strong indication of investor bullishness over the last 3 months. The Real estate sector – which does include some non-REIT securities - has the second most inflows of all equity sectors. Only the Technology sector has slightly higher flows. I would add that, given the size of the Technology sector versus the Real Estate sector, the flows into real estate are even more compelling.
Exhibit 2: Sector flows
Short interest figures tell a similar story. The Real estate sector has a very low short interest ratio – although it did increase slightly last month. A low short interest figure indicates fewer investors believing that the sector is undervalued and that a reversal is likely.
Exhibit 3: Short interest
A look at sector momentum paints the same picture. Real estate has the highest momentum score of all equity sectors and, according to the Valuation Composite Score, is reasonably priced.
Exhibit 4: Momentum
Fund manager survey
Another way of measuring investor sentiment is the Bank of America Merrill Lynch (BAML) survey of global fund managers, which reflects how money managers are allocated to various asset classes. These managers oversee a combined $600b in assets and are a completely different group than that surveyed by the American Association of Individual Investors.
This survey of global investors is also useful because, historically, it has also been a good contrarian indicator. The survey results indicate how long or short these managers are within each sector or segment of the market. The author of the report, Chief Investment Strategist Michael Hartnett, admits the value of its use as a contrarian signal.
It makes sense if these managers control a large chunk of assets. If they are all long, then chances are they have bid prices up to a point where valuations become less and less attractive in positions they hold, and more attractive in positions they don't currently hold. If you want to sell high and buy low, you sell when prices are high and when managers are mostly long. Eventually, these funds flow out of these currently favored sectors and into others.
The survey results are shown below. Note that the survey is measuring positioning relative to history using a z-score from a normal distribution. I won't get into the statistical details here, but the positioning of Equities, for example, has a z score of -0.8, which means that managers are slightly to moderately underweight to equities. For the stat nerds, this means managers are 0.8 standard deviations below where they are usually positioned.
On the other hand, these global fund managers are overweight REITs, by slightly more than they are underweight Equities.
Exhibit 5: Survey of global fund managers
Just as importantly, the cash position is overweight, indicating a higher-than-normal amount of cash available to invest. Fund managers' cash balance is high at 4.6%. Bank of America Merrill Lynch considers cash levels above 4.5% to be a contrarian buy for equities and below 3.5% to be a contrarian sell.
When you combine this with the underweight to Equities (and Staples, Industrials, Energy, etc.), it is a bullish sign for Equities and those specific sectors. Although, I will say this - the over/underweights aren't extreme. I would consider it a much stronger signal if managers were more than 1 standard deviation away from their average allocation. This is the case for UK equities, where managers are currently 1.2 standard deviations below their average weight - but this article is about REITs, so we will leave it at that.
And, what does the survey tell about REITs? As expected, the investor sentiment around REITs is very bullish. If we use this as a contrarian signal, we should expect short-term weakness in REIT share prices.
Equities up, REITs down?
So, the sentiment is bullish for REITs but bearish for equities. If the fund manager survey is truly a contrarian signal, we should expect equities to outperform and REITs to underperform. This would imply that REITs and equities might become less correlated. And, this has already been the case.
Exhibit 6: Correlation
REITs have become less correlated with equity markets generally. The correlation of daily returns on the FTSE Nareit All Equity REITs Index with the China CSI 300 Index was a relatively low .09, but fell to essentially zero from April through mid-May. (A correlation of 1 indicates perfectly positive correlation, while a correlation of -1 is perfectly negative correlation. In other words, a simplified explanation is that a correlation of 1 means that two assets move in the same direction all the time.)
REIT correlations with the Nikkei and Hang Seng indices went from low levels in prior years, to negative in recent weeks, meaning that when one of them is up, the other one is down more often than they were in the prior period shown. REITs also saw a decline in correlations with the FTSE 100 and S&P 500 during this period.
REITs, in contrast to many firms in the S&P 500, have low exposures to import and export markets, as their business is driven by domestic commercial real estate markets. This domestic focus has sheltered REITs to a certain extent, from trade war risk. For example, as global equity markets posted their largest decline in four months on May 13, the FTSE Nareit All Equity REITs index was unchanged at the close. This muted response of REITs to developments outside of the United States helps reduce risks in diversified portfolios that otherwise would be more vulnerable to global events.
So, if the trade war risk increases, REITs will probably (continue to) outperform equities – contrary to what our sentiment indicators are showing – but leading to ever more extreme levels of sentiment.
A record level of fund managers are certainly hedging against a stock market fall, according to the Bank of America Merrill Lynch survey of global fund managers.
Exhibit 7: Protection against a sharp fall in equity markets
If the trade war risks were to dissipate, however, equities could rally at the expense of REITs.
While little may be gleaned from changes in investor sentiment, identifying extreme levels of positive or negative sentiment appears to offer a glimpse of where the markets may be headed, or at least an indication that they cannot continue to go in the same direction for much longer.
Sentiment is not a flawless contrarian indicator, however. When we consider what extreme levels of sentiment are, we are usually comparing it to a previous occasion, which might not repeat itself even if it does seem to rhyme. In other words, the previously extreme level may be exceeded or the amount of time that sentiment remains at extreme levels may be prolonged. Timing the market reversal, therefore, is almost impossible.
There are also other factors that need to be considered, such as prevailing valuations, economic data, Federal Reserve policy, and other macro trends - and allow for a large margin of error in your forecast.
I don't believe any of the major triggers for long-term REIT price weakness are present, such as sharply rising interest rates, recessions, and extremely high valuations, to name a few. In fact, I think those risks are fairly limited. However, as I've mentioned in several recent articles, I do believe REITs are fairly valued overall and that as a sector, I don't see much price upside. Where investors might find opportunities for both income and growth are in some of the REIT sub-sectors whose fundamentals have been improving and whose stock prices don't yet reflect those improvements.
So, while we might be slightly underweight to real estate in our tactical asset allocation, we do see opportunities in specific sub-sectors and names.
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