Stocktake: Are markets irrationally exuberant?

The Dow Jones Industrial Average did something last Thursday it hadn’t done for almost two weeks – it declined, ending a run of nine consecutive daily gains and seven consecutive all-time highs. Is irrational exuberance taking hold?

Some indicators suggest elevated sentiment. CNN’s fear and greed index, a composite tool tracking seven indicators, has denoted “extreme greed” lately. Sentiment polls of financial bloggers show bullishness has spiked. Weekly inflows into equity exchange-traded funds (ETFs) tracking benchmark indexes recently hit 11-month highs. Bullishness among newsletter writers, as measured by Investors’ Intelligence surveys, has hit its highest level since April 2015, just prior to last year’s market top; current levels are just below the so-called “danger zone”.

Nevertheless, other indicators suggest sentiment is surprisingly subdued. American Association of Individual Investors polls show bullishness has been below historical averages for a record 37 consecutive weeks; this hesitancy, Charles Schwab's Liz Ann Sonders notes, actually resembles the uncertainty seen in the wake of the 1987 crash. Similarly, Merrill Lynch's latest monthly fund manager survey shows cash levels among fund managers are at their highest levels since the aftermath of 2001's September 11th attacks. Even Jeremy Grantham, the famously bearish value investor, admits there are "still no signs of an equity bubble about to break", with cash reserves and other indicators of bearishness "weirdly high".

In short, sentiment is elevated in some quarters but there’s little evidence of irrational exuberance.


Nothing bearish about a low Vix

Nevertheless, a host of commentators argue complacency is everywhere at the moment, as evidenced by the collapse in the Vix, or fear index.

The Vix, which is based on the price of index options bought to protect against market declines, spiked to a high of 26 in the aftermath of the Brexit vote. Last week, it fell below 12, following the biggest four-week decline in the Vix’s 26-year history.

The speed of the decline is certainly remarkable, given last month's pandemonium. The Vix is now in the lowest decile of historical readings, Pension Partners' strategist Charlie Bilello noted last week. High Vix readings are associated with panic, and markets typically gain big in their aftermath; does that mean the current calm augurs ill for equities?

No. Bilello found the S&P 500 usually gains over subsequent one-, three-, six, nine- and 12-month periods, with markets averaging one-year gains of 10.5 per cent.

That doesn’t mean low Vix readings are bullish – in fact, average gains were slightly below normal in each of the above-mentioned timeframes. Rather, the moral of the story is that while high readings are bullish for stocks, there is nothing bearish about a low Vix.

Technicals suggest rosy year ahead

Similarly, just as there’s no evidence that a low Vix is bad for stocks, there’s no evidence for the notion the current momentum reflects some unsustainable advance. In fact, evidence continues to suggest the current rally has legs.

Last week, 87.4 per cent of stocks traded above their 50-day average – a higher reading than 95 per cent of instances over the last 15 years. However, as Pension Partners noted in April following a similarly elevated reading, above-average gains typically follow over subsequent one-, three-, six, nine- and 12-month periods; six-month gains average 9 per cent, 12-month gains average 14.8 per cent.

Similarly, technical analyst Ryan Detrick last week noted stocks had gained 20 per cent over the previous 110 trading days. There have been 20 such instances since 1980, with stocks gaining over the following year on 19 occasions.

Another example: the advance-decline ratio, which measures the number of advancing and declining stocks, recently hit heights seen on only 13 occasions over the last 67 years, according to The Chartist newsletter. Three months later, stocks gained on 12 occasions; over six months, stocks had gained every time.

This time may of course be different, but evidence-based investors should pay no heed to the lazy assumption that stocks have necessarily raced too far, too fast.

Nervous fund managers don’t fancy equities

Indeed, while contrarians may not fancy buying near all-time highs, Merrill’s aforementioned fund manager survey suggests investor positioning more closely resembles that seen at market bottoms than market tops.

During February’s panic, StockTake noted that cash levels had hit a 15-year high of 5.6 per cent – an “unambiguous buy signal”, as Merrill said at the time. Today’s cash levels are even higher; investors have piled into bonds, despite collapsing yields; managers are now underweight global equities for the first time in four years; a record number have taken out downside protection for the next three months.

This is extraordinarily defensive positioning, given that furious rallies usually catalyse investors’ animal spirits. Fund managers are nervous and preparing for trouble; if none is forthcoming, that cash may eventually be put to work, fuelling further gains.