Tag Archive: stocks

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.

Recent rally in “junk stocks” is not unusual

Financial headlines have been captivated recently by explosive behavior in certain “meme stocks” that have been the subject of intense speculation by online retail traders as well as some hedge funds. This has been accompanied by a general trend of outperformance by smaller, money-losing, heavily-shorted, and volatile stocks (sometimes referred to as “junk stocks”, similar to risky high-yield “junk bonds”).

Other signs of “froth” include aggressive use of SPACs (Special Purpose Acquisition Company, or “blank check” company that raises money to acquire private companies), historically high trading volumes and activity in short-term call options, and growing margin debt.

This has raised broader questions about why “junk stocks” seem to be rallying much more than “quality stocks” and whether this is historically unusual.

The short answer is: no, this is not historically unusual under these circumstances. The specifics vary, but similar patterns have been seen in the past when markets are recovering from a sharp decline and policy support is very aggressive.

The first chart below plots the recent (past year) returns of the Dow Jones Thematic Market-Neutral Style indices. These are hypothetical long-short indices (i.e., assuming equal dollars invested in offsetting long and short portfolios) based on widely-used factors, using the 1000 largest US stocks, and constructed sector-neutral.

The key points are:

  • Quality and Anti-Beta (low beta) are highly correlated, since quality stocks (defined by Dow Jones as those with high Return on Equity and low Debt/Equity ratios) also tend to be lower beta. Size (small-caps) is often negatively correlated with Quality and Anti-Beta (since small-caps are generally lower quality and higher beta). Risk is the key theme connecting these factors.
  • November 6th (where shaded area begins) is when Pfizer announced its first COVID-19 vaccine results.  This marked the point at which the recent themes really began: outperformance by low-quality, high-beta, small-cap stocks. This initially hurt the price momentum factor since those had not been the leadership areas previously.
  • The Value factor had a bounce in November, but since then has shown no net performance. Thus it is not Value that has been rewarded, but risk, in the period since November 6th.
  • It is also not coincidental that early November was when the US election occurred, and the results (fully decided in January) increased the perceived odds of additional aggressive fiscal stimulus. Such stimulus tends to benefit smaller, weaker (riskier) companies that had been hit hardest by COVID-19.
  • Thus riskier companies have had recent tailwinds from both COVID-19 developments and greater fiscal support.

Dow Jones Thematic Style Indices All

The long-term chart below shows the Quality and Anti-Beta factors since the data begin in 2001. We can see the correlation is clear over the longer-term, including the most recent few months.

Dow Jones Thematic Style Indices Quality AntiBeta

The key point here is that in each of the previous periods of post-recessionary aggressive stimulus (2002-03, 2009-13), higher risk (lower quality) stocks were rewarded as investors sought the biggest “bang for the buck” from the stimulus and recovery. Weaker, riskier stocks tend to get the most benefit from policy support, while stable, higher quality companies do not need it and get relatively less benefit. Thus the current conditions are not unusual, and fully consistent with a risk-on environment, in line with our other indicators that remain bullish for equities on a tactical basis.

Risk on? Not really since early June

In financial markets, it seems like “everything” is going up recently. Stocks, bonds, precious metals, even Bitcoin. Perhaps that should not be surprising given the huge amount of liquidity being produced by global central banks in addition to the fiscal stimulus earlier this year. That tends to have the effect of pushing asset prices up generally.

But when we look at relative returns of some key assets, it looks more like the “risk on” trend has not really gone anywhere since early June. That is, owning the riskier option within various asset classes has not generated excess returns to compensate for that extra risk since the recent peak in risk about June 8th.

As shown in the chart below, buyers of risk in many areas have not been rewarded for about two months now (shaded area since June 8th). Brief comments on each section of the chart are below it.

This could be a natural consolidation after a surge in return to risk after the late-March lows, or a sign that the impact of stimulus, and stimulus itself, is fading.  Many prices/valuations are back near pre-COVID levels even while the economy and earnings are still far weaker than they were in January. Uncertainty about additional fiscal stimulus, now that much of it has expired or been spent, and worries about the continued aggressive spread of COVID-19 in the US are potentially countering the positive hopes for vaccine developments and ongoing central bank support.

We will be watching these returns closely for indications of whether investors are getting properly “paid” for taking on additional risk.

High vs Low Risk Relative Return Measures

  • Top section: Global stocks, measured by the MSCI All-Country World Index (ACWI) have performed no better than long-term US Treasury bonds since early June, and are still far behind bonds on a year-to-date basis.
  • 2nd section: Similarly, within the fixed income market, long-term Baa-rated US corporate bonds have done no better than long-term US Treasuries since early June (despite the ongoing support from the Federal Reserve), and remain well behind Treasuries for the year-to-date.
  • 3rd section: High-beta stocks in the S&P 500 have lagged low-volatility stocks in the index since early June, even as the S&P 500 itself has moved somewhat higher.
  • 4th section: US small-caps have lagged large-caps since early June, and small-caps remain significantly more volatile.
  • Bottom section: Among commodities, industrial metals (copper, aluminum, zinc, etc.) that are used in manufacturing are typically a measure of global growth that rise when the economy is improving (“risk on”). Precious metals are more often preferred as an inflation or currency hedge (“risk off”). So while both industrial and precious metals prices have individually risen significantly recently, industrial metals prices have lagged those of precious metals since June.