Tag Archive: sentiment

Reviewing current stock vs bond sentiment

Despite what you might hear or read some places, investor surveys do not show an extreme level of optimism toward US stocks. Bullishness on stocks has in fact declined somewhat recently and is not far from long-term average readings.

Sentiment toward bonds, by contrast, has moved quite sharply and is now approaching extreme bearishness by the standards of recent years. This is not too surprising, given that long-term Treasury bond yields have recently risen to their highest levels since COVID hit early last year. The result has been that investors in long-term (20+ year) Treasury bonds have lost about 13% since the end of November and about 18% since the end of July.

One of our key measures of survey sentiment for equities is shown in the top section of the chart below. It is an average of several sources, each of which monitors the proportion of market commentators who are bullish or bearish on equities. They include Investors Intelligence, Market Vane, and Consensus Inc.Stock vs Bond Sentiment

Source: Mill Street Research, Investors Intelligence, Market Vane, Consensus Inc.

The average proportion of bulls on stocks right now is about 60%, down from a recent peak in January of 67%.  The average proportion over the last five years has been just over 57%, so the current reading is only slightly above average. The peak in the last five years (and in fact since at least 2003) was at 76% back in January 2018 (when the corporate tax cuts were going into effect), while the lowest point in the last five years was the brief reading around 33% in late March of last year amid the worst of the COVID-related panic. Readings below 50% on this metric are relatively rare outside of panic periods.

These survey readings stand in contrast to other sentiment-related indicators like put/call volume ratios, certain valuation metrics, or anecdotal “indicators” like the popularity of SPACs or the extreme behavior of “meme stocks” with heavy retail trading activity. Other market-based measures of risk appetite (e.g. relative performance of riskier stocks) suggest investors are still broadly in a “risk on” mood.

Sentiment readings that are not extreme in either direction tend to give less information about future returns. But we can certainly see that stocks have often done well when sentiment has been near current levels, as sentiment has been around these levels since August . Extreme bearishness tends to be the strongest signal for stocks, but occurs relatively rarely given the long-term uptrend in US stock prices.

The negative sentiment toward bonds suggests that the recent rise in bond yields may be getting somewhat stretched. If investors continue to assume that the Fed is not changing its current policy guidance and will keep short-term rates near zero for at least the next year or two, then long-term yields may not have too much further to rise.

Taking the next step, if equity investors are growing more concerned recently about risks that higher bond yields may cause regarding the level of stock prices (i.e., a higher discount rate reduces the present value of future earnings), then sentiment toward bonds is worth watching as part of the broader picture facing equities.

Still a risk-on environment, but option traders remain nervous

Markets globally continue to show strong risk-seeking behavior, a continuation of the broader trend in place for much of the time since late March 2020. That was the point at which monetary and fiscal policy activity surged to produce enormous stimulus in the US and globally.

Recent US legislation that included a total of about $900 billion in new fiscal support is now starting to be felt, and recent political developments have increased the odds of further fiscal support this year. Alongside this persistent fiscal support to counteract the severe economic impacts of COVID-19, monetary policy remains extremely accommodative. Near-zero policy rates and heavy bond buying programs are expected to be maintained for many months if not years, putting both monetary and fiscal policy firmly in the “highly stimulative” category at the same time.

This backdrop has allowed the strong demand for risky assets to continue, as reflected in many measure of market prices. Our chart below shows four such measures:Global Risk Appetite Measures

Top section: The MSCI All-Country World Index (ACWI) is a broad global equity index, and it has been outperforming the total returns generated by the ICE/BofA Merrill Lynch (ML) 10+ Year Treasury Index (measuring returns to Treasury bonds with maturities of 10 years or more). This stock/bond relative return series has recently moved above its pre-COVID peak as bond returns have been weak and stock returns have been very strong.

Second section: Here we plot our own custom index of global high volatility stocks (top decile of global stocks above USD$200 million market cap, ranked by trailing two-year historical return volatility). This index of risky stocks is a useful measure of investor risk appetite. It has posted powerful gains since the March low in equity prices, and continues to make new highs.

Third section: This shows the relative returns of the S&P 500 High Beta index versus the S&P 500 Low Volatility index. The High Beta index reflects the 100 stocks in the S&P 500 with the highest market beta (sensitivity to stock market movements) and is a measure of high-risk stock activity among US large-cap stocks. The Low Volatility index captures the 100 stocks in the S&P 500 with the lowest historical return volatility (both indices are rebalanced quarterly). Their relative return is another measure of risk appetite among investors based on the relative riskiness of stocks within the major US benchmark index. It has been rising sharply again after a pause over the summer and is also making new cycle highs.

Fourth section: Turning to debt markets, this plots the average credit spread on high yield (junk) bonds in the US. The credit spread measures the additional yield investors require over and above the yield on a US Treasury bond of the same maturity to hold the debt of a high-risk borrower (i.e., companies with weaker financial conditions and thus higher default risk). That spread surged in the immediate aftermath of the COVID crisis in March/April of last year, and then has been steadily declining thanks to the Fed’s aggressive support of the corporate bond market. Recently it has continued to make new lows (reflecting greater risk appetite among investors), and is now back to pre-COVID levels despite the ongoing economic turbulence.

So we can confidently say that investors are content to take on greater risk than usual with the expectation that government support for markets and the economy will continue. We also note that the volatility of stock prices recently has dropped back down to very low levels, another condition typically found when risk appetite is high and a bullish trend is well established.

Under these conditions, we would normally expect options traders to react to the low market volatility and favorable backdrop by reducing their expectations of short-term future volatility. This would typically be visible in the CBOE VIX index, which measures the expected level of market volatility over the next month embedded in S&P 500 index options prices.

But right now, we see that the VIX has held at relatively high readings, and allowed a wide gap to open up between implied future volatility and recent realized volatility. We can see in the chart below that normally the VIX and realized volatility move together and are closer than they are now.VIX vs Realized Vol

It appears that options traders do not expect the current stability in equity markets to continue, and are pricing in a significant rebound in volatility (which is typically associated with falling stock prices). Our analysis indicates that this tends to be a favorable contrarian sentiment indicator: when options traders are especially nervous about rising volatility (relative to actual volatility), it suggests that some investors remain unconvinced and underinvested, which can support further near-term gains.

So while some measures of market sentiment are clearly pointing to high optimism among investors (a worrisome sign from a contrarian sentiment standpoint), the VIX is currently providing a supportive sentiment reading in our view. With the market’s trend still strong and the policy backdrop supportive, risk assets could continue to rise at least a little while longer.

Energy sector has rallied, but optimism is already high on crude oil

The recent returns of the Energy sector have been dramatic: in just two weeks from its latest trough on November 6th (just before the Pfizer vaccine news hit), the S&P 500 Energy sector rose 37%, the biggest return of any of the major sectors by a wide margin. The overall S&P 500 index, meanwhile, returned only 3.6% in that period. Most recently, the gains in Energy have cooled somewhat, but the sector (as of Dec. 2nd) is still up 30% from its November 6th level, well ahead of all other S&P 500 sector returns over the period.

The magnitude of the outperformance by Energy over such a short period is by far the biggest such move since the S&P sector return data begins in 1989.

This extraordinary move needs to be considered in context however.

It follows a sustained period of massive underperformance by the Energy sector. Over the 12 months through November 6th, the Energy sector had a -51% return, while the overall S&P 500 returned +14%. And in fact, the Energy sector has been underperforming the broader market fairly steadily since December 2016.

So one could certainly argue that Energy stocks were heavily out of favor and due for a rebound, and the recent vaccine news, with its hopes for a return to more normal levels of travel (and thus fuel use), has provided the spark for that rebound.

But because of the math of compounded returns, the huge recent outperformance only makes up a fraction of the cumulative underperformance since the start of the year, as reflected in the top section of the chart below.

Energy Sector and Crude Oil

What about the price of crude oil that so heavily influences Energy stock prices? Interestingly, crude prices have risen recently but less dramatically than the Energy sector stocks have. The average price of crude reflected in the futures markets over the next 12 months (which avoids quirks related to any specific futures contract) is at the high end of the range it has been in since early summer, around $45/bbl but still well below levels seen at the start of the year (middle section of chart). Oil’s recent movements have also been related to the OPEC+ meeting going on now that will influence how much new supply will be put on the market next year, following sharp output cutbacks this year.

Energy stocks continued underperforming over the summer and fall even as crude prices were range-bound, so the recent outperformance of Energy stocks looks more like stock prices catching up with the level of oil prices (after lagging oil’s movements earlier) rather than a response to a new dramatic rise in oil.

Can Energy stocks keep going? While short-term momentum can of course persist, the recent move has been extreme and thus has pushed Energy stocks closer to overbought conditions on a near-term basis. The bigger question is whether crude oil prices will move materially higher and thus help drive another leg higher for Energy stocks.

The near-term outlook for crude does not appear especially favorable for a couple of reasons. First, the current trends in COVID-19 in the US and Europe have led to more concern about travel (and therefore fuel use), not less, at least for now. The vaccines that have been announced will no doubt help, but will not be widely distributed for several months. If OPEC increases production, as they are discussing, prices may not gain much even with better demand.

The other concern is that sentiment toward crude oil is already quite optimistic, according to the surveys of market strategists published weekly by Consensus Inc. The latest readings show 62% of strategists are bullish on crude oil (bottom section of chart), matching the highest readings in the last several years (and far from the historically low readings around 20% in March/April). It is somewhat surprising to see such elevated bullishness given the price action in crude oil – normally sentiment tracks the price trend in the underlying market more closely. This implies that the majority of traders are already positioned for the potential good news from a return to more normal crude demand next year. The risk is therefore the contrarian concern that if most people are already positioned for higher crude prices, the opposite becomes more likely (absent an external shock).

Once Energy stocks have finished catching up with the current level of crude prices, and the heavy pessimism the stocks have faced this year has fully eased, further gains may be harder to come by. High optimism towards crude oil, combined with the potential for increased oil supply if demand does improve, suggests that the longer-term trend of Energy underperformance will be difficult to decisively break on an intermediate-term basis.

Is the rebound in earnings estimate revisions peaking?

Our measures of aggregated earnings estimate revisions trends have shown some of their most dramatic movements on record this year, and now may be looking extended.

After reaching historically extreme negative readings in April/May amid the initial COVID-19 lockdowns, earnings estimate revisions activity has now lurched back up to extremely positive readings. Better-than-expected Q2 earnings reports and the effects of massive monetary and fiscal stimulus are now finally reflected in analyst earnings forecasts. However, with fiscal stimulus weakening (and little imminent sign of movement toward new stimulus) and no meaningful further scope for interest rate cuts, the “snap-back” in earnings estimate activity could soon drop off.

The first chart below shows our measure of aggregated analyst earnings estimate revision activity in the US, for our broad universe of over 2000 stocks (equally-weighted) on a longer-term time frame. The data are month-end values except for the latest data point.  The red line represents the “breadth” of estimate revisions, meaning the aggregate net proportion of positive versus negative revisions (changes) to forward 12-month earnings estimates over the prior three months (i.e., number of analysts who have raised earnings forecasts minus the number who have reduced forecasts, as a percentage of the total number of analysts for each stock, scale right). The blue bars represent the “magnitude” of the month-on-month changes in forward 12-month forecasts, i.e., the average percentage change in earnings forecasts from a month ago (scale left).

United States_AbsERS

We can see that the low point in April matched (or exceeded) the extremes seen in the 2008 Great Financial Crisis (GFC) period, which is not surprising given that the drop-off in economic activity this year was greater than in the GFC. However, the combined fiscal and monetary stimulus recently produced in response was also greater than any previous post-WWII period, and so revisions metrics have shown a faster and more extreme rebound than at any previous point in our data. Stock prices appear to have moved ahead of aggregate estimate revisions, raising the question of whether this apparent good news for earnings is already priced in.

Perhaps more concerning is the risk that revisions (i.e., analyst sentiment) have reached highly optimistic readings now and may already be starting to revert. The chart below is calculated identically to the one above, but plots the daily figures (rather than monthly) over the last three years. Here we can see that the blue bars are already coming down from their latest peak, suggesting that the upward momentum of earnings estimate revisions may be fading now that Q2 earnings reports are over. The breadth series (red line) is based on revisions over the last three months, so it encompasses a full calendar quarter and is thus more stable. If revisions breadth starts to turn down (as it did after the tax-cut surge in early 2018) alongside current elevated valuations for equities, then the recent signs of higher stock market volatility could persist into Q4.

United States_AbsERS_Daily

Negative sentiment on the dollar becoming extreme

One of the most notable trends in markets recently has been the weakness in the US dollar. After a choppy strengthening trend since early 2018 (as the Fed was tightening policy), the US Dollar Index surged in the immediate aftermath of COVID-19’s arrival in March. Since then, however, as monetary and fiscal stimulus engulfed markets and investor risk appetite returned, the dollar has been weakening versus a number of other currencies. Indeed, the dollar’s weakness has accelerated recently, and the Dollar Index has reached its lowest levels since May 2018.

The latest movement is in large part attributable to strength in the euro, which has a big (58%) weight in the Dollar Index among the six major developed market currencies in the index. However, the recent decline can also be seen to a lesser degree in the Fed’s Broad Dollar index that encompasses a wider range of currencies. Certainly the prospect of US interest rates across most of the yield curve being near zero for the foreseeable future makes the dollar less attractive now versus other currencies.

However, we are now seeing signs that bearishness towards the US dollar has become extreme, and such sentiment is likely correlated with broader trends in investor risk appetite.

When reviewing the data on sentiment toward the dollar, one key metric that has jumped out at us is shown in the chart below. It plots an average of the proportion of market commentators (strategists, newsletter writers, etc.) who are bullish on the US dollar as reported by Consensus Inc. and Market Vane (services which track investor sentiment). We can see that bullishness on the dollar has now plunged to its lowest levels in nearly a decade. And while sentiment can remain bullish or bearish for some time, we can clearly see where the heavy consensus view on the dollar is right now. It is thus more likely that the dollar’s decline is in its later stages rather than a newly developing trend.

Dollar Indices and Sentiment

Since the US dollar behaves as a “risk-off” currency (along with the Japanese yen and Swiss franc), selling the dollar is often a sign of risk-on behavior, and consistent with recent risk-on activity in equity and debt markets. Bullish sentiment toward stocks and bonds is also back to pre-COVID levels, so the dollar sentiment readings are consistent with those trends as well. With monetary and fiscal stimulus in the US fading now, the surge in the supply of US dollars is also likely to ease, and the US economy and inflation are likely to slow without additional stimulus. A reversal of the current lopsided sentiment trends would potentially be bullish for the US dollar and bearish for equities, though the precise timing of any such change is always a challenge.