In recent months, the US Stock Market provided a real mood swings. It is worth to briefly recall what has actually happened.
In the beginning of October, US shares has finally began to react to what is really going on in the world. Persistent rally on the American Stock Exchanges had to finally stop (at least for a while) considering that, the other continents have been experiencing declines on their exchanges. From October 1st to December 25th, main stock indices in the US has lost about 20% of it's value. President Donald Trump has decided then to organize a quick meeting with the Plunge Protection Team which is a team of big banks responsible for fighting against panic sell off's on the market. It is worth recalling that we have been dealing with the extreme pessimism among investors at that time.
Moreover, President of the United States said that "I think it's a tremendous opportunity to buy". Who took these words seriously has made a lot of money. From December 26, the shares prices have significantly increased which has been led by the small companies - the Russell 2000 index has increased by 27% within 2 months.
Interestingly, the recent weeks have been also very good for gold, oil and bonds. The US Dollar has strengthened as well. This unusual situation last week, led the Daily Sentiment Index (DSI) to the exceptional levels (DSI is the index gauging investors' moods against certain assets: 0 - extreme pessimism, 100 - euphoria):
Bonds = 78%
Shares = 88%
Gold = 90%
Oil = 91%
These data is as of three trading sessions ago. The first important issue is the fact that the optimism has been very high for all four assets. The last time we have faced such a situation in October 2007, at the beginning of the financial crisis.
The second important aspect is the fact that the Daily Sentiment Index is based on the moods of small speculators, who most often are wrong during the market's turn arounds (this is a quote from the DSI index description).
Where are we today? The optimism somewhat has weakened a bit, but remains on very high levels:
Bonds = 62%
Shares = 82%
Gold = 55%
Oil = 78%
On the one hand, the above data suggests that we need to be cautious, but also could someone say "wait, recently you have written that the rise in prices is mainly due to the buybacks..."
Unfortunately, the market reality is not black and white. We are always dealing with factors that have a greater or smaller impact on prices. Liquidity, whether in the form of a currency printing or buybacks is crucial, but do not forget that investor's moods are also significant. That is why it is worth looking at this closely and determine to what extent they have influenced on the last shares rally. This is important because if we come to the conclusion that investors are now fully involved in equities, this would mean that further increases will depend only on buybacks, PPT and central banks interventions.
Return of Optimism
The first indicator, we address is so-called "Smart Money / Dumb Money Confidence". The mood of smart money (theoretically better-informed market participants) is based on the basis of investor activity in the last hour of trading sesssions. Otherwise, the dumb money are the people who make purchases at the beginning of the session, e.g. based only on how the market has opened and following it. Usually when the optimism among dumb money is high, it also means a higher than usual probability of market declines.
For clarity: S&P 500 index performance on the graph is the black line.
What can we deduce from the chart? Optimism of dumb money is as high as a year ago, just a few days before the market correction and also much higher than at the beginning of October (before sharp declines). On the other hand, in both cases the level of smart money confidence (blue color) was very low. Today is at neutral level.
We treat smart and dumb money confidence as one of many indicators and we approach it with cautiosly because its methodology is not perfect.
The next two charts typically refer to the level of optimism on the stock market, both in the short and the long term. They are based mainly on the interest of investors in index options (derivative instrument where you can bet on increases or decreases in stock index prices).
First we show, the short-term optimism, which has been staying on high levels over several weeks:
Now a glance at the same indicator, but in the intermediate term.
Here, as in the case of dumb money confidence, we have the highest levels since January 2018.
Since we are talking about the market correction from the last year, it is worth to recall the table, which has been sent to readers of Marc Faber. It contains a list of indicators related to the sentiment and involvement in shares of individual investors and investment funds.
source: Marc Faber
The table has been created in December 2017. Later on, in January 2018, we have sold many profitable positions from our portfolio. At the turn of January and February 2018, the first market correction since 2 years took place.
First column on the table consists a few different indicators. Subsequent columns contain: the most pessimistic and the most optimistic level of a given indicator during the last decade (columns 2 and 3), the recent value of the indicator (column 4), the recent value against the last decade and the date of the recent value (columns 5 and 6).
We have decided to describe column 5 in the most simplistic way possible. Bulishness percentile at 90,98 or 99 means that all of these indicators have an extremely high level of optimism (higher than 90-99% of time during the last decade).
Now let's compare the values of several indicators starting from the end of 2017 till now. First, Intelligence Investors Bulls - Bears which is the difference between the number of optimists and pessimists in the market. A negative result means that prevails the view that stocks will fall. Currently, the share of "bulls" is 51.9% and "bears" is 20.7%. The difference is 31.2%. In the case of Faber's table, it was 46,7%. The difference is quite significant.
Next consider the AAII Cash Allocation indicator. AAII is an American Association of Individual Investors, and the index determines how much cash they hold in their portolios. Of course, the lower the level of cash, the more positive they are to the market. The more long positions they take the less cash they own that could push the share prices higher. In the Faber's table we had 13,9% share of cash in their portfolios. Today, it is just over 20%.
The last indicator we describe is NAAIM equity exposure, which is the level of involvement in US shares among active investment managers/advisors. In December 2017, it amounted to 109%, which means that they were 100% long and additionaly 9% long with leverage. At the end of January this indicator was at 85% level and today it is only 78%.
As you can see, the current indicators compiled with the end of 2017, suggest that today we are not dealing with euphoria in the markets. From our perspective, the share of cash in the portfolios of US individual investors is significant. It seems that they are not completely convinced that another great stage of the bull market begins.
We can see it as follows: the gigantic scale of buybacks, PPT interventions and the short squeeze have pumped up the market after December 24th. During the subsequent weeks, other investors have joined the rally, while some of them still have considerable doubts related to the recent declines. It is possible that some market participants are still waiting for all time highs - and then they will return to the market.
it is important to realize that retail investors still have some inventory left in their wallets. Artificial pump of the market may be a trigger for releasing this stock and then those who have bet 100% for declines will regret it.
Economy vs market supported by the FED
After the sentiment analysis it is worth to get a bit deeper into the US stock market which is larger than all other stock exchanges combined. So, let's have a look at the economy conditions and what has been happening at the FED conferences.
A few days ago we have had a very imporntat statement by Richard Clarida, Vice Chariman of the Federal Reserve. He said that the FED may consider the use of further (unknown) tools of a very loose monetary policy in the future. Those have not been introduced yet, because they have been considered... too extreme. We can not say with a certainty, but this statetement could be a sign of setting negative interest rates in the future in case of significant economic slowdown in the US.
Thus, we are in the environment where, on the one hand, Trump says that the economy is doing great and talks with China are going very well, and on the other hand, the activities of FED members tell us something completely different. It is difficult to talk about a strong economy when the head of the central bank announces the end of monetary policy tightening, and his deputy begins to talk about loosening it.
Both sides have some goals to achieve. Trump must play his role and maintain good mood among the voters, whereas the FED should follow and act preventively in the event of economic problems. Such problems slowly come to light. We have already written about the decline in retai sales in December. In turn, the latest data on inventories and sales (excluding oil) looks very bad - the green line shows the increase in inventories, gray - the drop in sales.
Unemployment data are also worrying. Officially, from November to January it has increased from 3.7% to 4% (in real terms, it is over 20%*). Such an increase looks quite innocent, but it is worth noting what the FED member Danielle DiMartino wrote about it: "over the last 50 years every time when at the top of the cycle the 3-month average unemployment rate crossed 6 months average (as it happened in January) the US economy has experienced a recession."
In our opinion, this is the scenario. American economy looks best in comparison to the competition, which does not mean that it looks good. FED members, knowing what is happening, slowly change tha narrative and prepare tools. As long as the data and company results do not look dramatic, buybacks drive the market. It is not possible to say whether the declines will come tomorrow or in a few months, but definitely we will see volatility this year. Therefore, buying VIX call options (those which bets on increase in volatility index) during the moments of extreme optimism (as after the information about the deadline shift for China tarrifs) seems to be an interesting solution.
Independent Trader Team
* in the US, when calculating the level of unemployment, over 100 million people who are outside of the so-called "workforce" are not taken into account. These include people who, gave up seeking for a job, after a few weeks.