Key takeaway: Investor optimism has been unwinding even as indexes have moved into record territory and breadth remains strong (NYSE new high list at its highest level since 2004). This week’s featured chart shows the spread between institutional and individual sentiment collapsing. This has tended to occur ahead of market strength, not weakness. While the risks from a strategic positioning perspective are undiminished (especially in the context of valuations and household equity exposure), the short-term and intermediate-term sentiment picture has improved in recent weeks as optimism has come off the boil. It looks to me like investor sentiment has moved off of the risk side of the scale and the weight of the evidence is turning more constructive not more cautious.
Sentiment Chart of the Week: Sentiment Spread, II less AAII
Key takeaway: Sentiment shifts last week seemed more reflective of weakness in the headliners than the new weekly closing highs in the equal-weight S&P 500. This is a healthy development, especially for active investors who are seeing the market coalesce around a new leadership group while optimism comes off a boil. For passive investors, the pain of loss is more acute. This risk for the market overall is that diminished optimism morphs into more meaningful pessimism and breadth digestion turns to sustained deterioration. We have not seen that. Even as options data shows more concern and weekly sentiment surveys turn more neutral, fund flows continue to display optimism. When this reverses, risks are likely to rise. From a strategic positioning perspective, risks are elevated and passive investors may just be starting to feel uncomfortable.
Key takeaway: Another bout of late-month market volatility produced quickly frayed nerves. The VIX spiked and put/call ratios moved away from excessive complacency. Our tactical sentiment indicators point to still-elevated optimism even as sentiment surveys have eased recently. Risks arise when breadth deteriorates and a sustained shift from optimism to pessimism emerges. We are not seeing this yet. The $78 billion of equity ETF inflows in February (over the past two months equity ETFs have seen daily net outflows on only 3 occasions) suggests excessive investor positioning, but the risks inherent in that have not yet been manifested. Despite last week’s volatility, cyclical sector leadership persisted and defensive areas made new lows. That does not suggest investors are moving quickly to a risk-off posture.
Sentiment Chart of the Week: XLU/SPY & XLP/SPY Ratios
Key takeaway: Optimism remains elevated when looking at investor positioning (equity ETFs have seen a quarter trillion dollars of inflows since the end of Q3) and demand for call options (up 60%+ over the past year). But sentiment concerns become more acute (and stocks more vulnerable) when optimism shows evidence of meaningfully unwinding. This week’s featured sentiment chart (ratio between HYG and LQD) suggests that rather than pushing back from the buffet and beginning to tighten their belts, investors continue to have a robust risk appetite. That doesn’t preclude an uptick in market volatility, but it reduces the risk of sustained weakness at this point.
Sentiment Chart of the Week: HYG/LQD Ratio and S&P 500
Key Takeaway: There is ample evidence of investor complacency, optimism, and aggressive risk-taking.
The behavior of the broad market (another breadth thrust last week and the weekly NYSE + NASDAQ new high list is at its highest level ever) suggests some of this may be justified.
Sentiment is likely to become a more acute headwind when rally participation narrows and/or optimism remains elevated in the face of market volatility.
For now, optimism has been revealed as a mile wide but only an inch deep, with concern rising the moment the market stops rallying.
