Market Indicators At Extremes
Each bull market and bear market has its own unique set of features and Wall Street invents a new narrative to explain the buying in each bull market and selling in each bear market. However several market-based indicators provide consistent guideposts across all markets. Three market indicators that we have found particularly useful throughout the years are (1) investor sentiment (2) margin debt levels, and (3) short interest as a percent of market capitalization. None of these indicators gives a perfect timing call for short-term trading. However for asset allocators positioning their portfolio over an intermediate/long-term horizon, adjusting a portfolio allocation according to these market indicators creates long-term out- performance.
Investor Sentiment
“Go with the flow until sentiment reaches an extreme, then reverse your positions”. This is a universal rule for trading. The challenge is recognizing when sentiment reaches a bearish or bullish extreme. Many, including ourselves, thought that we had reached a bearish sentiment extreme well before March 2009. Similarly, many well-respected market observers have been saying for several months that bullish sentiment is at an extreme. However, for long-term investors and asset allocators, would anyone regret today having bought stocks in October or November 2008? Similarly, we believe, in the not too distant future, few will regret having sold in the past weeks most of their over-valued stock or index fund holdings.
Where are we with sentiment today? Bulls say that investor sentiment is very optimistic, but not yet euphoric. Bears say that sentiment is already euphoric. Looking at our WMA Market Sentiment Indicator, we hit the “extreme optimism” mode in December, which only served to stall the U.S. equity rally for six–weeks. Our sentiment indicator (see description) uses both market-based sentiment measures and investor surveys. Sentiment has moderated since the December extreme, but remains very optimistic.
Another popular sentiment indicator is the CNN Money Fear & Greed Index. This index was nearing “Extreme Greed” a few weeks ago but has fallen back to a 62 reading of “Greed” as of March 9.
In sum, near-term, sentiment can get more euphoric and prices can go higher. But having recently hit a sentiment extreme on both indexes, one must not dismiss the possibility that the pendulum has already begun to swing away from extreme optimism/greed.
Margin Debt
When purchasing securities through a broker, investors have the option of using a cash account and covering the entire cost of the investment themselves, upfront, or using a margin account, meaning they borrow part of the initial capital from their broker. The portion the investors borrow is known as margin debt. When investors are bullish, they borrow money and invest more than 100% of their account, commonly known as “leverage”. Obviously playing with borrowed money is dangerous, and if positions get under water the investor is forced to sell. Otherwise he/she will receive a margin call and be forced to pay in more cash to keep the positions. Therefore, once something triggers selling in a security (or an entire stock market), many “leveraged longs” are forced to sell into the panic, amplifying the drop in prices.
The NYSE compiles member firm debit balances in margin accounts each month. We compare NYSE margin debt to real U.S. GDP. The chart below is very telling. The data is updated through January 2017. We can reasonably expect that margin debt increased, perhaps significantly, in February bring that ratio near the May 2015 peak. We highlighted the dates of cycle highs and lows over the past 30 years. For those who follow the markets or have studied market history, these dates should be engraved in your minds. Given that the prior two bull markets topped out with the ratio near 2.7%, those who say “this time is different” have not studied market history.
Short Interest
The total U.S. market short interest data is updated through February 28, 2017. Short interest is the quantity of shares that investors have sold short but not yet covered or closed out. As speculators become bearish on equities, short interest rises. We compare total short interest to the total U.S. market capitalization to get a meaningful ratio. We can see that our ratio has progressively declined throughout the bull market beginning in 2009. Once again we highlighted several dates. The best times to buy equities in this bull market have been when the ratio has spiked. Conversely, once the ratio drops, an opportunity to sell presents itself. No one can argue that the ratio level today at 7.5% represents a screaming buy for equities. With shorts having fled the market and the equity trade as crowded as it has been since at least 1999/2000, we could make a strong argument for sitting 100% in cash and disconnecting from equity investing for a while.
Conclusion
We believe that markets have fully priced in all the possible good news that Trump could bring to the U.S. economy and that valuations are ridiculously expensive. What is pushing the market higher at this stage are fund managers looking at this market in disbelief and holding too much cash. As performance lags, these fund managers are slowing capitulating and buying in. We think that most shorts have thrown in the towel already, as evidenced by are short interest ratio above. As long as small dips are bought, more late-comers will find the courage to send remaining cash into equities. We believe that this is a fools game that will end in a sharp market crash once most of the sidelined money in put into the markets. What day sidelined cash gets too low is anyone’s guess, but given our market indicators above, we can’t be too far away.
