Analysis

This one metric told you to buy in March and sell in August, let’s take a look at what it’s saying now

October 19, 2020

Investor sentiment can be vital to making sense of how the stock is going to move. At the end of the day, institutions push the market in either direction. Without knowledge of their strategies and their risk tolerance, it is hard to comprehend what may occur.

Today, we will look at investor sentiment and what that means for investors and their strategies.

Investor Essentials Daily:
The Monday Macro Report
Powered by Valens Research

Given the current political and economic climate we live in, it is difficult to predict what will happen in the stock market.

Constantly on the news, people are debating:

–   Where will the market go if Biden or Trump wins?

–   Will the market react more to a new positive announcement on stimulus or to news

that nothing will happen?

–   Is the market set up to drop if earnings are bad this quarter, or are investors

already pessimistic, so earnings that just “aren’t that bad” will send the market

higher?

Although knowing what will happen with certainty is impossible, we may be able to understand how the market will react to upcoming events.

In the short-term, investor sentiment gives us the best signal for how the market will move when faced with an important event.

Understanding investor sentiment can guide market watchers as to whether the market will react severely to bad news, or shrug off negative headlines and surge higher on good news.

One powerful way to quantify investor sentiment is through the Equity Allocation Survey.

This data comes from the National Association of Active Investment Managers. Each week, this organization asks its member firms how much exposure they have to the equity markets.

The range of values the money managers’ report encompasses is -200% to 200% due to the possibility of leverage. The higher the value is, the greater the average investor’s exposure to equity markets. A higher value also implies a more bullish sentiment about the stock market.

The below graph shows investor sentiment since the beginning of 2019. Throughout 2019, investors were relatively neutral about the market.

It was not until this year when sentiment shifted. Even before the coronavirus actually reached America in March, investors began to move out of equities. By late February, investor sentiment was heading towards a two-year lows, near 20% equity market participation.

This hyper-pessimistic positioning in the market meant that in late March, barring an economic collapse, there was no one left to sell stocks. This oversold sentiment helped contribute to the strong bounceback in the market through April, as investors voted with their wallets, rushing back into the market.

The survey results continued to rise all the way until August. Investors were bullish because they were expecting the world to return to normal. Moreover, they held the belief that corporate earnings would continue to be strong after the pandemic.

It got to the point in late August where, in the span of five months, the market had gone from grossly oversold levels to levels that normally signal the market is overbought. There were no marginal buyers, because everyone was “all in.”

Unsurprisingly, with there being no marginal buyers, the market took a breather, and sentiment moderated. While in the last few months, investors looked past the potential risks to the recovery, in September and October they started to pay more attention, and moderate their confidence.

At first glance, this sharp drop in investor sentiment may seem bearish. However, this is like a safety valve for the market. The drop from overly exuberant levels helps wash out the market, and now that sentiment is more calm, it reduces the likelihood of a significant further drop in the stock market, as some people can be comfortable looking to value buy, investors aren’t all in.

Risks of negative events are no longer being ignored by the market, and market pricing is starting to reflect more uncertainty, as seen by the moderated equity allocation survey.

If negative events do occur, the market may already be prepared. Moreover, the risk of a further collapse is low given the credit signals we have been highlighting recently.

That means investors don’t have to worry about a potential for a massive drop in the near-term, and with more moderate sentiment, in the short-term, the market has just as much sentiment upside as downside. Sounds like a dollar cost-averaging market.

Best regards,

Joel Litman & Rob Spivey

Chief Investment Strategist &
Director of Research
at Valens Research