Research.LeutholdGroup

In our mid-month Of Special Interest, “Valuation Extremes: Here Be Dragons,” we examined valuation outliers as a measure of market sentiment. The hypothesis was that exuberance is reflected in investors’ willingness to hold stocks priced on an aggressive “vision” of the future; companies that are either habitually unprofitable or trade at a Price/Sales ratio above 15x.

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Stock market valuations may be considered the ultimate in fundamental measures, but they can just as easily be considered long-wave sentiment indicators. What causes equity investors to pay as little as 10x for S&P 500 Normalized Earnings at one point (March 2009), but pay more than 30x a dozen years later? The Fed printing press was in overdrive at both points; only emotions can account for the difference.

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Move over, Y2K! In late January, the squeeze of popular hedge fund “shorts” eclipsed anything we saw at the peak of the Technology bubble. But who knows? An even wilder event might be in store in coming months.

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The 200-day “report card” for this bull market shows the best initial-performance gain of all postwar bulls, but it’s come at a price. Investor sentiment is above levels seen at the same point of past bull markets… and there are the valuations. 

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Many pundits argue that sky-high valuations on stay-at-home stocks “prove” equity investors somehow remain fearful. It’s a nuanced, short-term argument, and there’s merit to it: We’d argue such fears have produced terrific relative values among “SMID” Cap stocks. 

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We get irked when TV pundits misrepresent the mood of equity investors as unduly pessimistic based one or two (or zero) data points. Among the dozens of “Attitudinal” indicators we track, an overwhelming majority show professional and retail investors have jumped back into the fray.

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Long-term sentiment indicators have carved out a four-month pattern similar to what we’ve observed in Large Cap valuation measures. That’s no surprise; valuation is a sentiment measure.

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We didn’t see the coronavirus coming and, like millions or perhaps billions of others, underestimated its likely economic impact when it began to spread. But stock market risks were high well before the virus hit.

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Market bulls remain mystified by the lack of enthusiasm for stocks given the proximity of U.S. indexes to all-time highs. They view this relative indifference as a contrarian positive—the “wall of worry” argument.

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Here are some brief follow-up notes on topics covered in recent months’ Green Books.

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The need to sound contrarian has become a borderline obsession among market pundits. Media opportunities for talking heads have exploded in the last decade, forcing those who hold the safest consensus views to falsely portray themselves as lonely and misunderstood market mavericks.

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This issue of Leuthold Quick Takes reviews the conflicted nature of investor sentiment as seen by Doug Ramsey (Chief Investment Officer) and Jim Paulsen (Chief Investment Strategist).

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One of the more impressive feats that bullish pundits have pulled off is their successful portrayal of themselves as lonely and misunderstand contrarians even as the eleventh year of a cyclical bull market grinds on.

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As the market rebound has extended, we’ve noted its striking similarities with the rally of 1999—one that might have been the most speculative in U.S. history.

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Christmas Eve came not with snowfall but a market freefall which was the worst-ever recorded for that date.

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It’s been one of the worst years on record for diversification, with our hypothetical All Asset No Authority (AANA) portfolio down 7.2% YTD through yesterday. That’s the second-worst year for AANA since 1972, and there’s probably not enough time left for performance to undercut 2008 (-24.9%) for the bottom spot.

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After a strong 2016 and a “Bridesmaid” (i.e., sector runner-up) performance in 2017, the Materials sector seemed primed to benefit from the “late cycle” character of the economy in 2018.

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In the first week of October, the share of newsletter bulls topped 61% just as the NYSE percentage slid to 41%. Maybe it’s a seasonal thing… the last time that happened was October 2007.

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During each of the last five months, the U.S. economy has shown a broadening array of “late-cycle” characteristics.

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Our shortest-term put/call measure has yet to reflect the level of fear usually triggered by a correction of this size. Meanwhile, the market setback has done almost nothing to stymy the optimism of either market newsletter writers or mutual fund timers.

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We impatiently published this study two months ago instead of properly waiting for full-year numbers.

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Tax cuts, a strong economy, and daily stock market records have lifted measures of investor sentiment to levels not seen in two decades. But sentiment is only a slightly better timing tool than valuations (which is not saying much), and there’s plenty of room for excitement to build before a final top is at hand.

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Evidently, being a bull in a bull market is no longer good enough.

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Stock market bears had a field day when the latest Investors Intelligence sentiment survey (Chart 1) saw the percentage of bullish newsletter writers spike to its “highest level since 1987.”

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The MTI’s Attitudinal category has held stable over the last several months, an impressive (and contrarily bullish) feat considering the steady onslaught of new bull market highs.

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The S&P 500 was up 6.4% YTD through March 3rd, a bit above its average annualized gain of 5.9% since 1926. In other words, 2017 would be a good year if the books were closed today.

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We revisit our “Red Flag Indicator” of prior bull market tops versus today. Usually most of these internal market measures will deteriorate in advance of the final bull market peak. At the latest S&P high, three of the seven leading measures had raised Red Flags, by not confirming, but two of them (DJ Transports and the NYSE A/D Line), are within just ticks of new bull market highs.

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The S&P 500 once again remains on the verge of a new bull market high, thanks in large part to the bubble in another asset class: Bonds.

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Positive forces may be transient. Be wary of EM’s high correlation to commodities and Chinese stocks.

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New developments have lifted sentiment toward oil and Energy names, but we caution bottom-fishers to be mindful of risks. The fundamentals in the oil patch do not yet support strong oil prices going forward.

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This month’s “Of Special Interest” allots eight pages to the (opposition) view that the correction is over, featuring charts we find the most threatening to our bearish stance. Based on its sudden popularity among the press and punditry, the indicator in this chart—highlighting the air-pocket in investor confidence—perhaps should have been part of that feature. Here’s why it wasn’t.

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One of the drawbacks advantages of tracking so many market indicators is that one can invariably cherry-pick a single measure that supports a given narrative.

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We wrote in the January book that 2015 would serve up no shortage of excuses for the Fed to hold off on tightening all year. Whatever window the Fed may have had is now closed.

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When the “most hated bull market on record” finally suffers a steep decline, it’s reasonable to expect that the hatred might evolve into true revulsion.

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The U.S. stock market has largely shrugged off the latest round of worries related to China’s stock market collapse, the new down-leg in crude oil, a more hawkish tone in Fed-speak, and sizable second-quarter declines in S&P 500 sales and earnings.

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The Volume Oscillator discussed in this section is one of several encouraging developments within our Attitudinal work that has sent that category to its least negative reading (-57, Chart 1) since July 2013.

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Has the recent collapse in crude oil prices presented us with a good opportunity for an outright commodity investment? No. Energy stocks aren’t on our radar screen either.

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Last year will certainly go down as the bull market year in which investors were finally retrained (as they usually are, late in every bull market) to buy the dips. Most of our Attitudinal measures—ranging from option activity and bear fund assets, to surveys of investor sentiment—show retail investors finally shaking off the worry that gripped them for most of the bull market’s first five years.

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Extreme market viewpoints get the headlines, but it’s baked into our disciplines that we will (occasionally) be noncommittal.

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We’ve been negative on industrial commodities for some time, reflecting the persistently (and unsustainably) high levels of investment evidenced by our Global Group analyses of commodity-oriented industries.

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