Ramblings of a Portfolio Manager

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.