Signs that the stock market should see better days are emerging in a surprising place: bearish sentiment among individual investors and hedge funds.
Historically, bearish investor sentiment has been a signal that it's a good time to buy stocks. That may be the case now, according to several indicators of confidence among individual investors. Indeed, while the Dow Jones Industrial Average (.DJI) and S&P 500 (.SPX) have both rallied more than 12% since the market bottomed on Dec. 24, consumers appear to view the comeback as a head fake.
As Bespoke Investment Group o-founder Paul Hickey pointed out in a Wednesday report, the percentage of consumers who are bullish on the market declined to 30.9% in January, the lowest level since July 2016. The percentage of consumers who are negative, meanwhile, rose to 38.6%, the highest level since December 2012. The last time the spread was this wide was February 2016–right around the lows of the 2015-2016 market correction, Hickey wrote.
Surveys of investor sentiment conducted by the American Association of Individual Investors also show extreme bearishness. The AAII surveys showed a bull/bear gap of -20% in favor of the bears on Jan. 2, according to Lori Calvasina, head of U.S. equity strategy at RBC Capital Markets. The only time that gap got much worse was during the financial crisis. Historically, when the spread breaks below -10%, the S&P 500 has been positive 83% of the time over the next 12 months, with gains averaging 11.5%, Calvasina pointed out in a report Wednesday.
It's too early to tell if institutional investor sentiment has also washed out. One sign will be the next update on equity futures positioning, issued by the Commodities Futures Trading Commission. The CFTC publishes the data on Friday afternoons, but it's been on hiatus during the government shutdown. This Friday's report could be illuminating.
One indicator of bearish sentiment among institutional traders, however, may be in hedge-fund positioning. According to Macro Risk Advisors, hedge-fund exposure to the S&P 500 has declined sharply, recently reaching five-year lows. "Hedge funds are increasingly buying puts for equity risk protection," Vinay Viswanathan, derivatives strategist with MRA, tells Barron's. "They've been taking risk off." That skew to bearish put options (which rise in price if the market falls) is also near five-year lows, he adds. That may not be a good timing indicator, but it does suggest that there may be more fuel for stocks if hedge funds turn positive.
Of course, these are just a few timing signals that may confirm one's predisposition toward believing in the rally (a common investor tendency to be overly optimistic). Investors should also put contrarian signals in context to the bigger picture. Issues that could derail the rally include a negative outcome in trade talks with China; another government shutdown after the deadline for the federal budget lapses on February 15; and profit warnings from large companies, indicating that Wall Street estimates are heading lower.
Investors are also closely watching commentary from the Federal Reserve for the direction of rates hikes and monetary tightening, and there may be trouble across the pond if Britain can't find a graceful way to exit the European Union, with the deadline for Brexit fast approaching.
And if you want to be talked off the bullish ledge, there's always an economist who can do so.
"Make no mistake, the earnings season has been a bit of a dud so far and guidance, to be polite, has been less than spectacular," wrote economist David Rosenberg of Gluskin Sheff in a note to clients Wednesday. He favors "bonds and bullion" as a ticket to gains, noting that gold-mining stocks are faring exceptionally well (as my colleague Andrew Bary recently noted in a bullish take on gold stocks).
"Success in 2019, much like 2018, will be knowing when to sell the rallies and, more generally, just staying out of trouble," Rosenberg wrote.
We would agree that investors should try to stay out of trouble; how they do that, though, is up to them.
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