December 11, 2020 glacierinvest

Sentiment is possibly the most important element of investing in stocks. We all get caught up in valuations and fundamentals, which are important, but valuations can become inexplicably extreme in either direction for longer periods of time than we might anticipate and unjustified fundamental expectations can be construed in any light to support a narrative. Sentiment is what ultimately causes distortions in asset valuations and justifications for unrealistic fundamental expectations. Sentiment is what drives stock prices.

Understanding where sentiment is at a given time and being able to synthesize what that means for asset valuations and your asset allocation is a critical element to successful investing. Don’t get me wrong here, timing the market is a fool’s errand but the combination of sentiment, valuations and fundamental expectations can provide important insight into whether you should be more aggressive or more conservative in your asset allocation. As Howard Marks says, it’s all about getting the odds on your side.

Sentiment Today

We discussed sentiment and valuation in last week’s post. I shared the chart below. Valuation on this metric is at all-time highs. A red flag for sure but not an omen of imminent price declines.

Here’s a chart of call option volume that supports the chart above. As a reminder, call options are contracts that provide you the option to buy a stock at a certain price (strike price) on a specified date. Options have a lot of leverage which makes them attractive for people that want to supercharge their returns in either direction. Investors clearly have bullish expectations for stock prices. Otherwise option volumes would not be at such ridiculously high levels (relative to history).

The next chart reflects risk appetite by comparing the price of a high beta ETF to a low volatility ETF. High beta stocks are more volatile, meaning their gains and their losses are greater than the average market gains and losses. When investors are aggressive they will bid up high beta stocks. When investors are fearful or concerned about future returns, they will exit high beta stocks and flock to low volatility stocks. The current ratio is at its highest level since 2011, reflecting a lack of inhibition among investors we hardly observed in the previous decade.

This chart shows the number of stocks trading above their 200 day moving average price. This measure depicts the breadth of participation in the current market rally. The percentage of stocks trading above their 200-day moving average is the highest it has been since 2009 when the recovery from the Great Financial Crisis began. A broad rally is generally a healthy rally so that’s good news. Good breadth also reflects positive investor sentiment.

All indications suggest market sentiment is very high with current valuation levels lining up nicely with sentiment. Interestingly, consumer sentiment is at odds with market sentiment which is potential red flag. Consumer sentiment is the pulse of the people. Have investors gotten ahead of themselves by discounting too far into the future? Or are consumers not feeling great because of the increasing intensity of the pandemic again. It’s challenging to reconcile at times. The key to remember is consumer sentiment reflects how consumers feel today while the stock market reflects how investors feel about the future. In other words, while consumers may be focused on today investors are looking past today to the next several months to years ahead.

US Index of Consumer Sentiment Chart

The final chart for today is the CEO Outlook Index from the Business Roundtable. This indicator reflects company boss’s outlook for businesses going forward. It is now above pre-pandemic levels, reflecting a high level of confidence among business leaders about their future prospects. This chart lines up with overall market sentiment.

In summary, market sentiment is high, valuations are high, CEO sentiment is healthy and consumer sentiment is fairly lackluster. I wouldn’t characterize this as a great entry point for new new investment but I don’t think selling out makes sense here either. Being flexible, having a plan and maintaining the discipline to stick to the plan are especially important in market environments like these.