Friday, 21 March 2014
Guest Post - Equities: Frothy Sentiment
"The good news is, we're not bankrupt. The bad news is, we're close." - Richard J. Codey
Please find below a great guest post from our good friends at Rcube Global Asset Management. In this post our friends go through the frothy sentiment building up in the equities space:
The MSCI World (developed markets) briefly tested its 2007 all‐time highs last week.
The strength in US equities explains most of the rise since 2009, but more recently Europe also helped the advance. The remarkable thing about this is how quickly sentiment towards stocks has reached and in many indicators even surpassed previous peaks in euphoria.
The indicator that has really caught our attention lately is the % of US IPOs with negative earnings. Most observers would have guessed that the 80% level reached back in 2000, at the height of the tech bubble, would never be reached again, but we are almost there again. Bloomberg reports that currently about 75% of all IPOs are money‐losing companies. So on top of the fact that rising equity issuance is negative for stocks’ expected returns in aggregate, the poor health of companies issuing shares is another medium‐term warning.
This goes hand in hand with extreme retail optimism which can be also tracked by looking at the RYDEX bull bear ratio. This is more interesting than the classic bullish/bearish ratios because it is based on actual money invested and not on surveys. It tracks the ratio of AUM between bullish and bearish RYDEX funds. As the chart below shows, it is at all‐time highs.
The net debit margins at the NYSE has reached almost 300bln and penny stocks’ trading volume has soared.
We also notice that the US market "breadth" is poor. The S&P Small Cap Index (S&P 600) has been printing new historical highs for 12 consecutive months with fewer and fewer shares trading above their 50 days moving average. Indexes are lifted by a small number of shares; this kind of negative divergence is rarely a good sign.
Additionally, we are now amazed to witness that Short VIX ETFs are almost as popular as Long VIX products. For us, who have been consistently selling equity volatility on spikes from 2009 until early 2013, when both retail and investment professionals were pouring money over Long volatility instruments at the worst possible times (vol was mispriced and the vol term structure curve was steep), it is astonishing to see retail investors now doing the opposite with vols in the low teens and the term structure now flat or slightly inverted.
While most of these indicators are usually useless to time equity markets on a short-term basis, they are nonetheless very useful for longer term expected returns.
From a long term technical analysis perspective, the US market is in an expanding wedge pattern. Each high is higher than the previous one, while each low is lower than the preceding bottom. The pattern ends once the third top is in; the "technical" target is lower than the 2nd bottom (March 2009 in this case).
This is the same pattern as in the 1970s.
From a behavioral finance point of view, the extreme levels of sentiment indicators we are watching make that catastrophic scenario a remote possibility that needs to be carefully examined. An energy price shock, similar to both 2000 and 2008 (fast rise in oil and gas prices) would seriously increase the odds of that happening. This is why, a move for Brent above 113 and followed by a sharp upside acceleration would send in our opinion a very negative signal for global stock markets around the world.
"You never want to have to give your child bad news of any kind." - Jonathan Dee, American novelist