10 Jan Market Extra: Investors should be pessimistic about the rise in stock-market optimism
One of Warren Buffett’s favorite stock-market truisms is that investors should be “fearful when others are greedy and greedy when others are fearful.” Right now, the investing world looks much closer to the greedy side of the scale, which more and more analysts are citing as a reason for caution.
Over the past month, there has been a rash of indicators that both retail and institutional investors are getting giddy over the market, which has rallied to multiple records, seen little in the way of volatility, and is poised to go a historic amount of time without even a mild pullback. While market bulls have plenty of factors they can point to in order to justify their positive views on the market, skeptics say the good vibes are too positive, possibly setting up a market that can’t match expectations.
“Amidst all the euphoria it is worth noting that, by some measures, market sentiment is becoming excessively optimistic,” said David Joy, chief market strategist at Ameriprise. “Contrarians take note.”
According to the AAII investor sentiment survey, 59.8% of polled investors are bullish on the market, meaning they expect prices will be higher in six months. That’s the highest level in about seven years, and those gains have come on fast, with optimism soaring 30.5 percentage points since mid-November.
Retail investors, according to a recent Deutsche Bank analysis of consumer sentiment data, view the current environment as “the best time ever to invest in the market.” They’ve followed through on that view, with TD Ameritrade reporting that its retail clients ended 2017 with record levels of market exposure. In December, the AAII stock allocation index jumped to 72%, its highest level since 2000, according to Dana Lyons of J. Lyons Fund Management.
Last month, Morgan Stanley wrote that cash balances for Charles Schwab clients reached their lowest level on record in the third quarter, opining that retail investors “can’t stay away” from stocks. Institutional investors, meanwhile, were “loading the boat on risk,” with “long/short net and gross leverage as high as we have ever seen it.”
Margin debt, which is viewed as a measure of speculation, has been at elevated levels for more than a year. According to the most recent data from NYSE, it hit $580.95 billion at the end of November, its fifth record in a row, and up 3.5% from October. Records aren’t rare—according Bespoke Investment Group, more than 23% of all monthly readings are records—but debt rose basically throughout 2017. The 11 highest readings on record all occurred in the 11 months of 2017 for which the NYSE has data.
These trends are occurring against a backdrop of economic strength. Corporate earnings are growing at their fastest pace since 2011, and they’re are expected to get another boost from the recently passed tax-reform bill out of Washington. At the same time, the labor market and other economic data are at multiyear highs while interest rates are low by historical standards. Furthermore, the expansion is global, with countries around the world growing and seeing their stock markets rise.
Among the economic indicators near records, an index of small-business optimism from the National Federation of Independent Business hit its second-highest level ever in November.
J.P. Morgan on Monday wrote that the fundamental backdrop for global equities was constructive, but “having said that, we note that there is some complacency appearing, the consensus is overwhelmingly bullish and the positioning is already long.”
Those gains have led to valuations that are seen as stretched by many metrics. The relative strength index, an indicator of technical momentum, is at its highest level since 1995, which indicates the S&P 500 is at its most overbought level in more than 20 years.
Over 2017, nearly 77% of those polled by the Investors Intelligence Sentiment Survey were bullish, the second-highest annual average percentage in the 54-year history of the survey, according to the Leuthold Group. Historically, market returns following such readings have been tepid, at best. The highest reading in the history of the survey occurred in 1976; over the subsequent year, the S&P fell 11.5%.
“Years with average sentiment readings above 70% were usually followed by years with disappointing stock market returns, with an average S&P 500 loss of -0.2% in the nine prior instances,” wrote Doug Ramsey, the Leuthold Group’s chief investment officer. He added, “smattered among those years were a couple of double-digit gains (including a recent one), leaving market bulls at least a reed of hope.”
A dip of 0.2% would hardly be a catastrophic return, and Morgan Stanley argued that the currently high levels of optimism may matter more in the short term than the near term.
A year ago, investors were quite cynical and had yet to show many signs of optimism during this great bull market,” the investment bank wrote. We suggested they would finally enter the euphoria stage in 2017-18. With monthly [relative strength indexes] at the third highest reading in 90 years, institutional investors holding their highest gross leverage in 12 years, individual investors the most bullish in 10 years, it looks like we are there.”
Morgan Stanley added that “This can be a bullish signal in the intermediate term (3-6 months) but is generally a negative signal over the near term (1 month).”