Equities Getting Frothy
U.S. equity indexes began breaking out to new record highs at the very end of October and over the past week have added a few points each day at record levels. At the same time, the VIX volatility index (also known as the fear index) has fallen back to 12, about the floor level over the past 18 months. In a recent article from the first week of November, “Equity Markets Roll On Towards Euphoria“, we pointed out the several legitimate reasons for investor optimism (seasonality, market reaction to macro data, trade optimism, and a renewed “Fed put”). But we also warned that much of this good news was likely already priced into equities. Based on our assessment below, our preference is now to use cash on a more significant pull-back and not in the heat of the action today.
This past week we have seen several signs that the optimism, while still not euphoric, is making equity indexes a bit frothy for our taste. Empirically, we are judging that most fund managers and investors with cash are positioned for a year-end rally and higher equity prices. It is a legitimate question now to wonder who will be the marginal buyer to push equity prices even higher. Barring significant progress on U.S.-China trade, we also see no catalyst to bring money parked on the sidelines into equities now.
Aside the technical price action, with the S&P 500 rallying past 3120 and the Dow closing in on 28,000, we are pondering four signs that make us cautious despite everything being so great for equities.
1- Rolling Year-End Price Targets. Last December, the consensus of bank equity strategists was way too low with their year-end S&P 500 forecasts. At the start of the second half, all the strategists were forced to revise higher their year-end S&P 500 forecast. This past week several strategists frantically moved up their year-end targets, six weeks out. Here were the strategists’ targets at the start of November.
Our observation is that the index is already well-above the targets of all but two strategists. Either everyone is wrong or the S&P 500 is too frothy at current levels.
2. “We’ll Add More”. How many times will we hear folks go on financial media shows and say, “if prices pull back, we’ll add more to our positions”. Let’s stop and reflect on this. These fund managers or investors are so confident that even if prices pull back, they’ll just double down. But if they are so confident, why are they holding cash? Or are they not really holding cash? This overconfidence is another sign of frothy markets. Be sure, whenever we see a significant pull-back in equity prices, all investors will (as usual) think twice about “adding more to positions” in light of the new, negative development.
3. 7th Inning Stretch. Everyone gets excited about the year-end stock rally. Let’s recall that the traditional year-end stock rally is framed from a lower starting point after a traditionally weaker August to October period. This year prices did not pull back much in the “worst period of the year” for stocks. From the summer high of 3025 on the S&P 500, the index only fell to 2840, a -6% correction. With a relatively small give-back going into the year-end rally period, it seems doubtful that equities will have enough a tailwind to last six weeks longer. Even if you believe in a Santa Claus rally to close the year, we’d be surprised if equity don’t require a 7th inning stretch in order to reboot rally mode for the final weeks of the year. Perhaps the 7th inning stretch for the S&P 500 will just be the sideways churning that we have seen for the past week. Or perhaps some weak-hand individual and retail investors, all comfy for the year-end rally, need to get shaken out.
4. Sentiment Is Now A Headwind. Euphoria was seen in late 1999 and early 2000 in Tech stocks. Today is clearly not what we experienced in 2000. Nonetheless, a tradable cycle top does not require euphoria. Our WMA Sentiment Indicators have been very reliable, as it combines both investor survey data and market sentiment indicators (VIX, put-call ratios, etc). We highlighted recent peaks in the WMA Sentiment Indicator, along with their dates. Our sentiment reading this week is ABOVE the levels seen in January 2018 and July 2019. Bulls can dismiss this indicator, since the economic backdrop is better today than at the prior two recent indicator peaks. But this type of revisionist thinking tends not to work in equity trading.
The American Association of Individual Investors sentiment survey for the week ending November 13 climbed to a 40.7% bullish reading. Last time the bullish sentiment was above 40% was on May 9, 2019. Bullish sentiment also hit 45.6% in October 2018 just before the market correction. Again, we are not at euphoric levels, but this is a frothy environment for equities.
The major large cap U.S. equity indexes just keep hitting record daily highs. European indexes are at highs since 2015. While no one can dismiss a linear move higher on the S&P 500 to 3250 by year-end, we realistically put a lower weight on this outcome. There are two more likely scenarios for equities. First is the scenario of a sideways equity trade to digest recent gains off October lows. This scenario may be playing out already this past week. For us, this is a bullish scenario. The other higher possibility scenario for equities is the -3% to -5% pull-back to shake out weak hands and comfortably-installed end-of-year rally investors. We cited several signs of froth and overconfidence in this article that may need to be corrected by the latter scenario before the year-end rally resumes. Our investment hypothesis is that of the second scenario (digestion of gains through a few days of profit-taking). New investment money should be held onto now, despite the temptation of this one-way rally higher.