The S&P 500 just reached a new record high after a wild ride that saw the index plunge 34.07% in 23 trading days, a record.
We believe the risks of an intermediate decline are higher than average and would advocate a more cautious stance toward equities right now.
In January 2018, September 2018 and February 2020 there were a variety of sentiment indicators that reached extreme levels and signaled the possibility of a correction.
Currently, we count 9 indicators that are at/near/above the more extreme readings than previously experienced prior to significant intermediate corrections.
In the following charts, we highlight the indicators within an historical context.
Number 1: Large Trader Call Buying
Large traders are defined as those buying more than 50 contracts. It goes without saying that call buying is a levered way to express a bullish view. As such, this indicator should be viewed as contrarian in nature. When it is extremely elevated, this is a negative input.
Number 2: Small Trader Call Buying
Small traders are defined as those buying fewer than 50 contracts, more indicative of retail investors. Small traders’ bullish call buying exceeds anything we’ve ever seen before. The current rate is well above the level that existed in February 2020, prior to the bear market.
Number 3: LOBO Put/Call Ratio
Large Orders Buy at Open is called a LOBO trade. Those orders can be call ratios or put ratios. By comparing the volume of bullish call contracts to the number of bearish put contracts, we get the LOBO put/call ratio. In times of euphoria, this metric typically sinks to low levels. Recent readings are more negative than what we saw in February 2020.
Number 4: ROBO Put/Call Ratio
Similar to the LOBO ratio, we can see the behavior of small traders by looking at Small Trader Buy at Open orders. Again, these can be bullish calls or bearish puts. Among small (retail) traders, the fear of the downside is completely absent as the ROBO put/call ratio is at all – time new lows. This is a very negative input.
Number 5: Options Speculation Index
This indicator doesn’t differentiate by size, but rather by trade type. The buying of calls or the selling of puts is a bullish option strategy. Inversely, the selling of calls and the buying of puts is a bearish trading strategy. The Options Speculation Index captures these various options strategies. The Index is more bullish than levels seen in February 2020.
Number 6: National Association of Investment Managers
This a survey of professional investment managers attempting to measure the percent long exposure they are employing in client portfolios. At 101.2, this suggests that in aggregate, investment managers are not just 100% long, but actually leveraged long. While this indicator is just below its January 2018 reading, it is above what we saw in February 2020.
Number 7: Rydex Total Bullish Assets
This indicator captures the amount of assets in Rydex funds that are pursuing bullish strategies, i.e. long. The current reading matches the reading from February 2020 and exceeds the levels seen in January 2018 and September 2018.
Number 8: Rydex Total Leveraged Bull Assets
Some Rydex funds seek to provide 2x or 3x the daily performance of certain benchmarks. Flows into these leveraged funds have been quite strong since the March low. Currently, this indicator is higher than February 2020 and just below January 2018. This should be viewed as a contrary indicator that is a negative input right now.
Number 9: Percent Showing Excess Optimism-Pessimism Spread
SentimenTrader will take all their indicators that express optimism (call buying, leveraged asset flows, etc.) and all their indicators that express pessimism (put/call ratios, options speculation, etc.) and consolidate them into a couple of simple indicators: 1) Excess Optimism, and 2) Excess Pessimism. They then take the spread to understand the net bullish stance of their indicators. Current readings are similar to January 2018 and February 2020.
* * *
Bonus Chart 1: Banks & Capital Markets on Different Planets
We’ve all read lately how asset prices seem dislocated from the pain Main Street business is feeling.
At the end of July, banks reported to the Fed their policies toward new loans. Banks reported that 71% had tightened standards on commercial and industrial loans for large firms and 70% tightened standards for small firms. This is the kind of credit crunch normally seen in recessions and historically reflects much wider corporate spreads. Wider corporate spreads have been generally associated with lower P/E ratios for stocks.
One way banks protect themselves in credit crunches is to increase the spread, on loans they extend, to wider levels relative to their own funding costs. In the most recent period, almost 59% of banks reported increasing loan spreads to large firms and 54% increasing spreads to small firms. This behavior from banks has been seen in recessions and is generally associated with much wider corporate spreads.
Wider corporate spreads are generally associated with lower P/E ratios for stocks… we repeat.
Bonus Chart 2: Stocks Ahead of Credit Markets
Off the March 23, 2020 lows, stocks have experienced a record run, catalyzed by the improvement in credit markets. Our contention is that credit markets are ahead of the banking system in terms of assessing risk. We think stocks are even further ahead of the credit market in pricing in an increasingly rosy scenario. Our model of relating credit spreads to stock performance suggests the possibility that stocks are 12% above fair value.
In our view, strong moves higher in equities don’t take place from this sentiment backdrop.