Wednesday, May 20, 2015

Investor Opinions Have Become Extremely Uniform, And That's Not Good

Summary: Investor opinions have become extremely uniform. By some measures, they are the most uniform in 25 years. In the past, this has corresponded to a period where equities have lacked significant upside momentum. That appears to be a quite likely outcome until investors become more varied in their market outlook than they are today.

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Last week, the number of investment advisors who are bullish US equities dropped below 50%. For many, this was seen as sign of bearishness.

Indeed, relative to the past 16 months, investment advisors were relatively bearish, to the point where the S&P has had a strong tendency to move higher in the ensuing weeks (yellow shading; chart from Investors Intelligence).

But take a step back and notice that what it is now considered a bearish extreme was considered a bullish extreme two years ago (red lines, above).

Taking a further step back, over the past 25 years there hasn't been another period where opinions on the direction of the stock market have been more uniform than in the past two years. Even during the booming 1990s, a time when stocks appreciated much faster than now, saw periods where investor opinions regularly oscillated from many bulls to many bears (chart from Yardeni).

The Investors Intelligence data fits a pattern that is prevalent now across many sources measuring investor sentiment, either through opinion surveys or their investment allocations.

Yesterday, BAML released their May data of global fund manager investment allocations (full post here). The past two years data is neatly summarized in one chart that compares managers' allocation to high beta, cyclical equities relative to the safety of bonds, cash and defensive equities like consumer staples (blue line; chart from BAML).

What you can clearly see is that prior periods of extreme undulation, where fund managers oscillated from defensive to full risk-on, have been replaced by a high tight range where managers are essentially always positioned for equity outperformance.

Also released yesterday was a study by Sentimentrader comparing the spread between the large number of indicators he tracks showing investor optimism or pessimism. What the study shows is that a persistently high number of indicators have been showing investor optimism relative to those showing pessimism over the past three months (lower panel). In fact, the spread has only once been wider in the past 15 years, and that was immediately after the bear market low of 2003 (more on this study is here).

Part of the rationale behind all of these studies is that the performance of US equities has been strong; for example, there hasn't been a correction of more than 10% since June 2012. While 3 years is a long time without a correction of 10%, the 2003-07 bull market was completely devoid of 10% corrections, going 4 1/2 years without a single one. So there must be more to it than that.

Critics of the Fed will say that the equity market has become skewed by central bank liquidity. Those same critics also predicted that US equities would collapse after QE3 ended, but that was now 7 months ago and equities are still moving higher. This rationale is too simplistic.

Part of the complexity of the current market environment is that a typical economic expansion runs about 5 years. The current expansion is in year 6 and yet employment growth is at a 20 year high, wages are now growing sequentially and measures like housing construction are reaching new post-recession highs. The genesis of 2008 recession was completely unlike those of the past 80 years and so recent economic analogues are not useful.

Whatever the reason, there is a significant and bullish skew among investors. More likely than not, that skew will be unwound in 2015.

Referring back to Sentimentrader's chart above, the timing and course of that unwind is unclear: in 2003 and 2004, equities traded sideways for many months before going higher. But that sideways trading eventually wore out many investors. In 2011, equities also moved sideways for many months but then fell 20%. 2000 and 2007 were of course market peaks; given the economic backdrop, that seems to be the least likely outcome this time.

But a period where equities continue lack significant upside momentum is common to all of the periods mentioned above. That appears to be quite likely until investor opinions become less uniform than they are today.

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