Headline risks are everywhere, and as an investor, you must keep your head on a swivel and human reactions in check so that you’re not drawn into well-written narratives that promise to unveil the mystery of financial markets, says Landon Whaley of Whaley Global Research.
This week’s Headline Risk dives further into the concept of measuring market sentiment. In last week’s “Headline Risk,” I called out JP Morgan for basing their current market perspective on narrative rather than data. JPM released a report stating, “For asset allocators, what is thus important is scale exposures to avoid an overly concentrated portfolio, one way of scaling exposures to the consensus trading themes is by limiting exposure to the most crowded ones.” The report went on to say, “those crowded trades include: short the US dollar versus cyclical developed-market currencies, long copper, and long Bitcoin.”
Wielding investor positioning data, I quickly slew JPM’s “crowded trades” thesis. But JP Morgan is not the only Wall Street firm peddling financial market fiction without the numbers to back it up.
The Golden Slacks
Goldman Sachs is now telling us that "equity positioning is extremely stretched" based on the fact their “Sentiment Indicator (SI) registered +2.0 standard deviations above average, which represents a 98th percentile reading since 2009." Underneath the hood, every sub-index in this indicator is tapping the highest percentile ranks in the last ten years. Unfortunately for Goldman, this indicator is typical Wall Street: it looks sophisticated, but it's dead wrong.
First, let’s evaluate the usefulness of the “Sentiment Indicator” as a market-timing tool. Goldman’s Sentiment Indicator has registered a reading of 2.0, or greater, on five separate occasions over the last ten years. Over the ensuing three and six-month period following those “stretched” readings, the S&P 500 delivered an average return of +6.2% and +4.3%, respectively. The numbers tell us unequivocally that an “extremely stretched” SI reading is bullish for stocks, not bearish, as Goldman implies.
Second, the latest CFTC non-commercial net long positioning report, like Shakira’s hips, doesn’t lie. There are currently -26,901 net short contracts in the S&P 500 and another -12,571 net short contracts in the Dow Jones Industrial Average. Investors are slightly bullish for US small caps (26,842 net long contracts) and the Nasdaq 100 (11,704 net long contracts), but these positions are far from being “extremely stretched.” In Z-score terms, both small-cap positioning (Z score of 0.35) and the bullishness in the Nasdaq (Z score of 0.15) are near the lowest levels we’ve seen over the last 12 months.
I’m not telling you a bedtime story about how investors feel about stocks. I’m using the dagum data, which tells us unequivocally that investor positioning is not “extremely stretched,” either bullishly or bearishly.
Goldman is not the only firm with a supercalifragilisticexpialidocious sentiment indicator.
Panic and Euphoria
Citigroup’s chief US equity strategist, Tobias Levkovich, referenced the firm’s own “Panic-Euphoria” indicator in a recent report. “Current euphoric readings signal a 100% probability of losing money in the coming 12 months if we study historical patterns – indeed, we saw such levels back in early September as well right before a selloff in stocks.”
Regardless of how accurate an indicator may predict future price action, nothing can provide 100% certainty. Levkovich’s statement is just asinine, especially given that it’s based on a single data point. Citi’s Panic-Euphoria indicator has only been at the current level on one other occasion, during the ’99 Nasdaq bubble. I don’t care what field of study you’re pursuing; you can’t draw a statistically valid conclusion from a single data point.
Wall Street isn’t the only industry engaged in the business of telling you how investors feel about the market; the media believes it has the answer too.
Fear and Greed
Many investors, professional and otherwise, follow CNN’s Fear and Greed Index, which is calculated using seven underlying gauges of “fear” and “greed.” Let’s evaluate each one.
First, there’s “Stock Price Strength,” which is determined based on the number of stocks hitting 52-week highs minus the number hitting new lows. This sub-indicator is pure garbage and has zero predictive value because it follows the S&P 500 (SPX) price path; it doesn’t forecast it.
Second, the “Stock Price Breadth” measures the amount of volume traded in winning stocks versus the volume in losing stocks. Here again, this indicator has a strong correlation to the price movement of the S&P 500, which means it moves in lockstep with the S&P 500, thus providing no information about the future path of the S&P’s price.
The “Market Momentum” sub-indicator evaluates the S&P 500 relative to its 125-day moving average, and the “Market Volatility” indicator looks at the VIX relative to its 50-day moving average. Moving averages have no predictive power whatsoever. You’ll have to take my word on this one; early in my career, I evaluated those averages eight ways to Sunday and found they provide no statistical edge in trading.
The “Junk Bond Demand” indicator had the same readings in July and August (when the S&P gained +5.2% and +6.2%) as it did in September and October (when the S&P experienced intra-month corrections of -9.4% and -7.4%). ‘Nuf said. Another input CNN uses is the options market. This input is a reactive measure and offers no foresight at all. Why? Because people buy puts after the market falls, and they purchase calls after the market rallies without them.
The final indicator used by CNN is the “Safe Haven Demand.” To debunk this measure of market sentiment, all we need to know is that it's currently indicating “investors are fleeing risky stocks for the safety of bonds.” Really? As we discussed earlier, investor positioning in stocks is neutral at best and far from indicating they are “fleeing.” As for bonds, one look at the investor positioning facts tells us that investors aren’t looking for safety in bonds; they are massively bearish on US Treasuries, all along the yield curve.
The Bottom Line
Measuring and mapping investor sentiment across asset classes is critical. We handle this crucial element of investing by calculating a Behavioral Gravity Index (BGI) for every asset we monitor.
Rather than use worthless inputs like moving averages, we harness the power of Chaos Theory and Fractal Geometry. We apply the tools provided by those disciplines to data sets such as short interest, analyst ratings, corporate insider activity, and futures positioning.
Our BGIs have an excellent track record of flashing a warning sign when an asset class is likely at a point of exhaustion, and the probability of a countertrend move is rising. That said, we have never had readings that indicated a 100% probability of what will happen in the future, so clearly, there is still room for improvement.
To learn more about Landon Whaley, please visit WhaleyGlobalResearch.com.
