What a difference a week and a half makes. The middle of last week, the world was coming to an end. As of this afternoon, the S&P and MSCI World were near new highs. What a whirlwind.
When we published our last monthly chartbook in January, right before the recent correction kicked off, several of our favored sentiment indicators were flashing signs of over exuberance. Now that markets have sold off and rebounded near levels observed in mid to late January, how has investor sentiment responded?
As with past corrections during this cyclical bull, sentiment has descended back into pessimistic to neutral territory fairly quickly. Again and again, investor sentiment has been much quicker to tuck tail and run to the pessimistic side when things go awry. This “wall of worry” and skepticism have provided a positive structural backdrop for continued advances over the past year and a half. Hopefully that pattern will continue.
Let’s move to some of the individual sentiment indicators.
First, let’s examine the CBOE equity put-call ratio. Higher ratios indicate higher bearishness (more put activity relative to calls). Last month, the put-call ratio had reached the lowest levels since late 2010. Now with the recent selloff, the 10-day average for the put-call ratio has rebounded to the highest levels seen since last fall. Granted, as the chart below shows, pessimism levels aren’t near levels seen last summer. Nonetheless, it’s hard to describe this market at present as being anything close to “wildly exuberant.”
Next, let’s look at the International Securities Exchange All Equities Index, which shows the number of calls traded for every 100 puts. In this case, higher levels indicate optimism and lower levels indicate pessimism. Again, we use the 10-day moving average to smooth out some of the volatility in the indicator. Prior to the correction, the indicator had reached the highest levels since early 2012. Since then, sentiment has fallen back below the longer-term average and back within the “pessimism range” we’ve observed since the middle months of 2012.
On the individual investor side, “neutral” remains the operative word. We use the Farrell Individual Investment Sentiment indicator, which is a formula based on the weekly AAII bull/bear/neutral survey numbers. Indicator levels above 1.50 indicate extreme optimism. Levels below 0.50 indicate extreme pessimism. Like the others, we use the 10-week moving average. At the end of December, 2013, this indicator moved as high as 1.15, the highest levels observed in two years. Since the correction, the indicator has moved down to 0.99, right in the middle of the long-term range. Note that individual investor sentiment reached bear-market-like pessimistic levels during the summer of 2012 right before markets embarked on the strong uptrend that has continued to this day. Even with massive returns over the past 18 months, this indicator has never escaped the +1/-1 standard deviation band on the upside.
Another indicator we keep an eye on is the ratio of 30-day S&P 500 implied volatility (represented by the widely followed VIX index) relative to 90-day implied vol (the VXV index). Out of whack moves to the upside in this indicator have coincided with short to intermediate term market bottoms in the past. As we can see below, this ratio actually spiked to the highest levels observed since the market upheaval associated with the European crisis at the end of 2011, which is interesting considering the peak to trough declines associated with the recent correction totaled approximately 5.6% while the peak to trough decline in the S&P 500 was 19% in late 2011 (and over 20% in overseas developed markets). Not to harp on the issue, but we again see that it doesn’t take much of a move in markets right now to ignite fear.
Add it all up, and we continue to see a market prone to jump to negative conclusions at the first sign of trouble. Until we see market enthusiasm jump through the statistical roof and remain steady above those levels (and see market participants remain significantly bullish even in the face of market cracks), we’ll remain reasonably optimistic on the intermediate term prospects for the equity markets. Yes, valuation is a concern longer-term. However, the ingredients that combine with overvaluation to mark major market tops haven’t lined up at this point.
