Key Takeaway: Investors continue to favor stocks as money relentlessly pours into equity ETFs. It’s no wonder, given that the main stock indexes are printing new record highs. Yet, a depressed risk appetite and an unsupportive breadth backdrop accompany the persistent push higher in equities. Though these suspect undercurrents aren’t apparent at the index level, we see signs that short-term attitudes are shifting. Bears are on the rise, with the average of the II and AAII bears trending higher. However, pessimism remains relatively mooted and optimism is still elevated when viewed through either a cyclical or strategic lens. The current environment suggests there is more risk than opportunity for equities from a sentiment perspective.

Key Takeaway: It appears the bulls are preparing to pack it up and call it a day. Dark clouds are starting to roll in, as the slow deterioration beneath the surface has taken its toll. New highs and a relentless rally in the major indexes paint an alternate reality versus the experience of the average stock--a reality that hasn’t quite sparked the interest of the bears so much as it’s exhausted the bulls. Active investment managers continue to taper their exposure, and advisory services have turned their least bullish in more than a year. A storm is brewing in the form of a re-set in sentiment. As it inches closer, the question becomes more of “when” and “how,” not “if.”  

Key takeaway:  There are signs of bears beginning to stir. Pessimism on the II and AAII surveys has reached its highest level since Q1 and put/call ratios show investors turning to the options markets for insurance rather than leverage. NASDAQ trading volume continues to unwind after surging to new highs earlier this year. This evidence of growing investor/consumer concern, especially when combined with deteriorating market internals and a disappointing macro backdrop, creates an environment ripe for a sentiment unwind. Whether a full unwind comes to fruition or not, rising pessimism tends to weigh heavy on equities after a period of extreme optimism.  

Key takeaway: Sentiment continues to argue a case for caution. Pessimism remains near historical lows. Nasdaq trading volume dwindles along with risk-seeking behavior. And with the economic surprise index slipping below zero, better than expected economic data no longer provides a tailwind. Yet, pockets of strength remain (including the earnings revision trend) and optimism has ticked higher across our sentiment indicators. Active investment managers have increased their exposure, throwing caution to the wind during a seasonally challenging period. All this does not lessen the real risks associated with the lopsided sentiment that tilts toward extended optimism.

Key takeaway: A “no fear” attitude envelopes a market marred by mixed signals and deteriorating breadth. Large-cap indexes push to new highs while small and mid-caps trend lower. We even see an expansion in new lows further down the cap scale. But on the surface, optimism shines. Yet, challenges could lie ahead as a lack of risk-seeking behavior suggests a weariness among investors, and seasonal tendencies lean toward a lackluster performance in the coming months. For now,  equities remain the popular choice among market participants as investor sentiment obscures the fragile reality beneath the surface.

Key takeaway: Optimism most likely peaked earlier this year, as options activity and equity exposure have continued to trend lower in recent months. Yet, our sentiment indicators show no signs of fear. Of course, it’s hard to imagine an environment plagued by fear when the S&P 500 and Nasdaq push to new highs. However, when we look beneath the surface new highs contract while new lows expand. It seems each day a new bearish divergence in breadth emerges, adding to the fragility and deterioration of an already shaky foundation. Without a supportive backdrop, a price correction or volatility event could lead to a meaningful unwind in sentiment.  

Key takeaway: A diminishing appetite for risk combined with deteriorating breadth creates a backdrop conducive to equity indexes catching down to the weakness that has been on display beneath the surface. While bulls remain elevated overall, that could change very quickly as the stage is set for a complete sentiment unwind. Optimism has already begun to edge lower, with AAII bulls dropping to their lowest level since October. Any major signs of adversity could rock the optimistic outlook of a market that has gone relatively unchallenged for the last year. 

Key takeaway: It’s bears on strike and bulls on parade. While it persists, it can fuel a rally. Whether it can persist is another question. We have already seen (particularly in less robust trading activity and a downward trend in the NAAIM exposure index) evidence of waning risk appetites. Earnings season may test investor resolve. Expectations are in the sky in terms of both results for the past year and estimates for the year ahead. If the earnings rebound is seen as slowing, investors may struggle to maintain an optimistic outlook for stocks, especially with valuations suggesting that they are priced for perfection at current levels.

Key takeaway: Record highs in equity indexes buoy investor sentiment that has remained optimistic without a significant challenge over the past year. Bulls ticked higher across our sentiment indicators last week, yet we still see evidence that risk appetite is turning (NAAIM Exposure Index, NASDAQ trading volume, overall levels of options activity). These new highs and levels of optimism must contend with the undercurrents of lackluster breadth measures and an absence of pessimism. Risks lie just beneath the surface. This raises the possibility of a more complete sentiment unwind when risks are realized and prices begin to falter.

Key takeaway: Even with some indicators backing away from extreme optimism, sentiment remains on the risk side of the scale. Optimism can be slow to unwind as hopeful investors typically hold on until price changes force their hand and compel action. Optimism fades slowly and then all at once (whereas, fear, when it emerges, spikes quickly, and then slowly fades). The decline in consensus bulls and the emerging  pattern of equity market exposure among active managers echoes a waning in risk appetite that can be seen in equity and options market trading volume. Longer-term sentiment indicators continue to point to an elevated risk environment. 

Key takeaway: Last week’s volatility unwound some near-term complacency, but there is still plenty of evidence of optimism in the system. Active managers increased their equity exposure and equity ETFs continue to attract inflows at a staggering pace (though certain sectors are starting to see outflows). A more challenging breadth backdrop poses a challenge, but with economic data continuing to surprise to the upside and earnings expectations being revised higher, excessive optimism may be slow to unwind. While risks are elevated from a sentiment perspective, they are not yet being manifested in terms of price. 

Key takeaway: From a breadth perspective, the market is challenged right now by a scarcity of new highs. From a sentiment perspective, it has to contend with a scarcity of bears. Options data shows complacency even as risk appetites remain diminished. Bears on both the II and AAII surveys are near their lowest levels since 2018 and ETF inflows remain elevated. The household equity allocation tilt (versus bonds) is its most extreme since 1972. Stocks are loved, bonds are hated. All of this is very well summarized by our chart of the week from the Bank of America Fund Manager Survey which shows virtually no one is expecting (or prepared for) market volatility in the months ahead.