Bullish Sentiment on us Equities is at a Recent High…and so is Market Pessimism Regarding the Bullish Sentiment on US Equities.
What a terrible time to invest. We hear it every day: the VIX is at a 2 year low, the put/call ratio is the lowest since January of 2006; US monthly stock market sentiment indices show the ratio of bulls to bears at 2:1, also a two year high; NASDAQ sentiment index is the highest since October of 2007; short interest fell 5.5% on both the NASDAQ and NYSE in December and, finally, the AAII Bull-Bear Spread is around 53%, also a two year high. All this points to investor sentiment at a near-term zenith and if you are a contrarian, as we tend to be, it’s about time to liquidate and run for the hills. The pragmatist in us, however, says hang on, not so fast.
A look at long-term mutual fund cash flows (courtesy of ICI), however, shows the movement back into US equity funds is only just beginning—a proxy for retail investor sentiment. In fact, net outflows from US equity funds stopped and turned positive for the first time only as recently as December 21st—and the net inflow number was tiny, dwarfed by flows into foreign equity funds by some 265:1. That trend continued through year-end with flows into US equity funds positive but tiny in comparison to those into foreign funds. For all the hand-wringing over rising rates, net cash flows into bond funds just went negative during the week of December 8th, continuing until the last week of the year when there was a big reversal, most likely due to asset allocation strategies pegged to the higher interest rate environment engendered by the recent rout in the Treasury market. Meanwhile, the flows out of Muni bonds continues amid fear of defaults by certain states. What to make of this? Well, if sentiment is so high on US equity markets, it has yet to be backed up by the money. And as Jerry Maguire would say…
A day doesn’t go by when we tune into one of the financial channels only to hear a half dozen market experts rehashing our sentiment analysis, using it as evidence that markets are overbought and due for a correction. We don’t necessarily disagree with them except for three important points: first, if everyone is so negative on everyone being so positive, doesn’t that sort of cancel things out? In our humble opinion, the answer is yes. Secondly, and we expect to be laughed at this given our view of technical analysis, the technicians look at all this bullishness with half see it as a good thing, half as bad. Synopses for several technical analyses:
The Pro:
At present, the short-term bullish outlook is supported by a strong technical backdrop, with the SPX advancing above the 1,250 area in mid-December. U.S. equity investors are more bullishly positioned than at any time in the last two years, figures show, following a sharp market rally since September. Investors currently have 10.8 times as many long positions as short positions -- bets on falling prices -- in the United States, the highest since the ratio was calculated two years ago, according to the data. Things that support this positive outlook:
1. Accelerating stock buybacks
2. Accelerating M&A activity
3. An extension of the capital gains and dividend tax cuts originally set to expire in 2011
4. The third year of a presidential term is historically bullish
5. An accommodative Fed
The Con:
We are seeing optimism enter the market recently, which means we may be vulnerable to a short-term pullback. For example:
1. Equity call buying relative to put buying on the Chicago Board Options Exchange and International Securities Exchange is at an extreme.
2. The CBOE Market Volatility Index (VIX) is now trading at a level that is twice SPX historical volatility. During the past two years, when the VIX is trading at such a high premium to SPX historical volatility, a mild to large pullback soon followed. The last time this indicator signaled was early November, ahead of a 3.8% retreat in the SPX.
3. For the first time since late April, domestic stock mutual funds experienced net inflows last week. The inflows are minute relative to the enormous outflows during the past three years, but one has to wonder if this eight-month "extreme" in optimism might precede a pullback in stocks? After all, during the past 10 years, the month of January experienced a correction, or marked the start of a correction, in five of those years (2002, 2003, 2008, 2009 and 2010).
• The AAII Investor Sentiment Survey measures the percentage of individual investors who are bullish, bearish or neutral on stock market for the next six months. As the masses are usually on the wrong side of market movements, particularly at tops and bottoms, sentiment indicator serve a useful function as contrarian indicators.
• The bullish sentiment (55.9%) and bearish sentiment (18.3%) readings are at fairly extreme levels, as also seen from the bull-bear spread being quite a bit higher than the market peak of October 2007.
• Sentiment indicators are fairly blunt instruments from a timing point of view and can stay at high / low levels for extended periods. However, when companies are overvalued and technical indicators overbought, overbullish sentiment indicators complete a threesome of tools arguing quite strongly for a cautious approach to stock market investment.
Since we don’t cotton well to technical analysis, the fact that their jockey shorts are all in a knot as to how to read the current markets is a good thing to us. When they all agree is when we hit the buy or sell button.
Our third reason to give pause before bracing for the coming sell-off is the ICI data. Yes, money is flowing strongly into equities….but it’s NOT going into US equities! In fact, the recent big flows out of bonds (only after they have sunk in market value by close to 20%) has been redirected into Foreign equity funds. Guess what? India is now down 6% for the year with many of the smaller Asian/Southeast Asian markets dragged lower in tow. So there is definitely some validity to watching the cash flows as an indicator of the retail investor coming in during a market’s last legs. The problem is, it’s not our market they are top-ticking. Predictably, they are chasing the past returns in India and the “Tigers” (or so they used to be called). We like that—because as retail left bond funds after having been burned, so too soon they will leave foreign equity funds after being burned…and where will they have to turn? The US, of course. What else is left? And it will be just in time for all the better economic data, which has been hitting the wires lately.
After a big move on January 2nd, the US markets have tread water, mostly with a downward bias. This is contrary to our, and many other fundamental analysts’ beliefs, that we would see a very strong run through the middle of January followed by a sell-off, which would be a buying opportunity. We’re not sure the sell-off is coming—or if we haven’t already had it (a consolidation as the technicians would say). Perhaps January will be a reverse of what we expect—early weakness followed by a month-end rally. That would sure put a knot in the socks of the fundamental guys as well as the technicians. We’re not saying that there wont be pullbacks, just that it’s too pat to try to call them based on the calendar and that, if they come, they should be short and shallow and present a good buying opportunity. Let’s not forget that the markets are still awash in liquidity and that European weakness/Chinese, Indian Inflation headline risk is not only discounted in investor’s minds but is being addressed in part with China willing to backstop Spain and Japan willing to pitch in to support Portugal. What other headlines do the Euros have to throw at us? And are there not piles of cash lined up for the day when China says “done raising rates?” If this market sells off the catalyst will have to come from within—we’ve heard the China/India/Euro record before.
Wednesday, January 12, 2011
Monday, January 3, 2011
Ramblings of a Portfolio Manager
Santa Claus smiled upon the US equity markets in December, delivering solid gains with much reduced volatility versus prior months. In this market environment, the Kettle Creek fund generated a strong positive return for the month as the high correlations among individual stocks, seen for most of the year, unwound allowing those with stronger intermediate-term fundamentals to outperform.
While 2010 can be characterized as the year investors in the US equity markets spent most of their time looking abroad and worrying, fretting over everything from debt defaults in Europe to inflation in China and military tensions in the Koreas--to name a few--December will be remembered as a welcome respite from global concerns, a month when investors turned their focus to the improved political landscape and strengthening economy at home. It was almost as if investors looked at the troubles overseas and decided, for a month anyhow, to adopt Alfred E. Newman's philosophy of “what, me worry?”
This isn’t to say that there was nothing happening in the global landscape to cause concern to investors at home. Ireland, one of the “I”s in the now infamous PIIGS (the second “I” having been recently added over concerns for Italy), continued to be thrust to the forefront as yet another over-leveraged, slow growth, entitlement-addicted European country in need of a bailout from the IMF and EU while Portugal, the “P,” loomed ever larger on the horizon as the next domino, followed potentially by Spain, the big “S.” China also continued as a global macro concern but for opposite reasons. In an effort to tame inflation in December the PBOC hiked bank reserve requirements for the third time in two months, followed by a Christmas day surprise of a 25 basis point hike in its discount rate. Suddenly, the same investors who have been calling the stated growth rates in Chinese GDP “falsely inflated” began to worry that the PBOC’s attempts to reign in the inflation generated by those “lies” would overshoot, slowing the “engine” of global economic growth too far and thrusting the world back into recession. And even while the mid-term elections in November improved the political backdrop at home, in December we were reminded that the bureaucrats are alive and well in Washington as the SEC launched a massive insider trading probe with some high-profile hedge-fund arrests while their counterparts on the other side of the hill at the newly created Consumer Financial Protection Bureau continued to attempt to weaken domestic financial institutions this time by drastically cutting debit card swipe fees charged by credit card companies.
Still, in December, investors believed that much of these concerns had already been discounted in the equity markets and a few early Christmas presents in their stockings helped them think more positively on
equities. On the European front, the IMF and EU moved much more rapidly than in prior situations to
staunch the bleeding in Ireland. Serious talk of a bailout fund to deal proactively with future crises ensued and China began buying up distressed bonds of many European countries (eschewing our own overpriced debt instruments), emerging as a potential financial backstop in future European debt dilemmas, particularly should Spain look to begin sliding into the same morass. As for China, while inflation fears persisted, a weaker-than expected PMI brought comfort to some that the tapping on the brakes efforts were beginning to work. Here at home our own PMI, Consumer Confidence, Industrial Production and Unemployment Claims numbers all came in better than expected and on the political front the Obama Administration rolled over on the Bush tax cuts, extending them another two years for all income brackets while unexpectedly tacking on a Social Security tax cut for all, an extension of unemployment benefits, more generous estate tax provisions and, best of all, a one-year 2% payroll tax cut with a 100% writeoff on capital investments for business. All of this positive news on the domestic economy caused many economists to lift their GDP forecasts for 2011 through 2012 by 50 to 150 basis points, something the markets had not been expecting.
With little new negative news and a spate of good political and economic data the US equity markets responded positively. The VIX dropped to at 3 year low, while Treasury yields began to climb despite the Fed’s efforts on QE2. The dollar climbed as well as did oil prices on expectations of economic strength. Suddenly, talk of a double-dip recession, rife over the summer, turned to hand-wringing over if the Fed would even complete QE2 and when they would start withdrawing liquidity ala the PBOC. In this market environment the Kettle Creek Small Cap Fund performed well as we have been exposed to the cyclical
sectors of the US equity markets all year long in the belief that the domestic economy would continue to strengthen, despite the turmoil in Europe. While this thesis hurt us during the downdrafts of May and August, when the talks of a European contagion were at their zenith, our discipline to stick with the thesis paid off in December. The strongest performing sectors in the fund were Financials, which were helped by the steepening yield curve, and Industrials and Materials, both of which got a boost from the improving economic data even in the face of a slightly rising dollar. Weaker sectors included Technology, to which we have been reducing our exposure, and Consumer Discretionary, which saw some profit taking after a nice run-up into Christmas.
We haven’t changed our outlook on the US equity markets, which continues to be favorable for 2011 and into 2012. We are a little concerned about the decline in Short Interest along with a recent bump in investor confidence—both signal that much of the good news in the Economy may be already discounted in investors’ minds and stock prices in the near term. We also have our eye on interest rates and energy prices with concern that the recent climb in both might begin to choke our nascent recovery. We expect, however, that the news flow domestically will continue to be positive and, though it will drive Treasury prices even lower thus further raising rates, will produce a net outflow from US bond funds and into US equity funds—something that hasn’t happened for over three years but the beginnings of which are just becoming manifest. That would signify an asset allocation shift among institutions as well as a return of the individual investor to the US equity markets. Given the relative size of the US bond market to the equity markets, such a cash flow reversal can produce sizeable stock price gains over the next several years.
While 2010 can be characterized as the year investors in the US equity markets spent most of their time looking abroad and worrying, fretting over everything from debt defaults in Europe to inflation in China and military tensions in the Koreas--to name a few--December will be remembered as a welcome respite from global concerns, a month when investors turned their focus to the improved political landscape and strengthening economy at home. It was almost as if investors looked at the troubles overseas and decided, for a month anyhow, to adopt Alfred E. Newman's philosophy of “what, me worry?”
This isn’t to say that there was nothing happening in the global landscape to cause concern to investors at home. Ireland, one of the “I”s in the now infamous PIIGS (the second “I” having been recently added over concerns for Italy), continued to be thrust to the forefront as yet another over-leveraged, slow growth, entitlement-addicted European country in need of a bailout from the IMF and EU while Portugal, the “P,” loomed ever larger on the horizon as the next domino, followed potentially by Spain, the big “S.” China also continued as a global macro concern but for opposite reasons. In an effort to tame inflation in December the PBOC hiked bank reserve requirements for the third time in two months, followed by a Christmas day surprise of a 25 basis point hike in its discount rate. Suddenly, the same investors who have been calling the stated growth rates in Chinese GDP “falsely inflated” began to worry that the PBOC’s attempts to reign in the inflation generated by those “lies” would overshoot, slowing the “engine” of global economic growth too far and thrusting the world back into recession. And even while the mid-term elections in November improved the political backdrop at home, in December we were reminded that the bureaucrats are alive and well in Washington as the SEC launched a massive insider trading probe with some high-profile hedge-fund arrests while their counterparts on the other side of the hill at the newly created Consumer Financial Protection Bureau continued to attempt to weaken domestic financial institutions this time by drastically cutting debit card swipe fees charged by credit card companies.
Still, in December, investors believed that much of these concerns had already been discounted in the equity markets and a few early Christmas presents in their stockings helped them think more positively on
equities. On the European front, the IMF and EU moved much more rapidly than in prior situations to
staunch the bleeding in Ireland. Serious talk of a bailout fund to deal proactively with future crises ensued and China began buying up distressed bonds of many European countries (eschewing our own overpriced debt instruments), emerging as a potential financial backstop in future European debt dilemmas, particularly should Spain look to begin sliding into the same morass. As for China, while inflation fears persisted, a weaker-than expected PMI brought comfort to some that the tapping on the brakes efforts were beginning to work. Here at home our own PMI, Consumer Confidence, Industrial Production and Unemployment Claims numbers all came in better than expected and on the political front the Obama Administration rolled over on the Bush tax cuts, extending them another two years for all income brackets while unexpectedly tacking on a Social Security tax cut for all, an extension of unemployment benefits, more generous estate tax provisions and, best of all, a one-year 2% payroll tax cut with a 100% writeoff on capital investments for business. All of this positive news on the domestic economy caused many economists to lift their GDP forecasts for 2011 through 2012 by 50 to 150 basis points, something the markets had not been expecting.
With little new negative news and a spate of good political and economic data the US equity markets responded positively. The VIX dropped to at 3 year low, while Treasury yields began to climb despite the Fed’s efforts on QE2. The dollar climbed as well as did oil prices on expectations of economic strength. Suddenly, talk of a double-dip recession, rife over the summer, turned to hand-wringing over if the Fed would even complete QE2 and when they would start withdrawing liquidity ala the PBOC. In this market environment the Kettle Creek Small Cap Fund performed well as we have been exposed to the cyclical
sectors of the US equity markets all year long in the belief that the domestic economy would continue to strengthen, despite the turmoil in Europe. While this thesis hurt us during the downdrafts of May and August, when the talks of a European contagion were at their zenith, our discipline to stick with the thesis paid off in December. The strongest performing sectors in the fund were Financials, which were helped by the steepening yield curve, and Industrials and Materials, both of which got a boost from the improving economic data even in the face of a slightly rising dollar. Weaker sectors included Technology, to which we have been reducing our exposure, and Consumer Discretionary, which saw some profit taking after a nice run-up into Christmas.
We haven’t changed our outlook on the US equity markets, which continues to be favorable for 2011 and into 2012. We are a little concerned about the decline in Short Interest along with a recent bump in investor confidence—both signal that much of the good news in the Economy may be already discounted in investors’ minds and stock prices in the near term. We also have our eye on interest rates and energy prices with concern that the recent climb in both might begin to choke our nascent recovery. We expect, however, that the news flow domestically will continue to be positive and, though it will drive Treasury prices even lower thus further raising rates, will produce a net outflow from US bond funds and into US equity funds—something that hasn’t happened for over three years but the beginnings of which are just becoming manifest. That would signify an asset allocation shift among institutions as well as a return of the individual investor to the US equity markets. Given the relative size of the US bond market to the equity markets, such a cash flow reversal can produce sizeable stock price gains over the next several years.
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