Investors should proceed with caution
To say that investors have been content with where markets have been heading over the past few weeks is an understatement, says Paul Stewart, managing director of the Plexus Group.
“Volatility, as measured by the Chicago Board Options Exchange Volatility Index (VIX), has fallen by 60% since October 2011 and 20% since the start of 2012,” says Stewart. “Volatility has fast been approaching historically low levels not seen since before the credit crisis began, as previously sidelined cash has been working itself into the markets and has resulted in a strong rally over the first six weeks of the year.”
“Looking at history it is important to note that when volatility subsides to historically low levels, like we've seen recently, it tends to generate its own reversal,” says Stewart. “This is based on the old contrarian principle that the crowd can't be on the right side of the market's trend for long. However, it should also be noted that the saying that retail investors ‘can't be right for too long’ can often be misleading,” he warns.
“We aren't justified in assuming that because contentment is high and volatility is low the intermediate-term uptrend for stocks is doomed. There is still a strong current of internal momentum behind this market, which argues against a major interim peak happening right now. However, it is important to take cognisance of some of the factors out there that point in the opposite direction, at least in the near term.”
According to Stewart, many big, technically oriented market participants have already been anticipating increases in volatility. “The market for options on the VIX itself has shown this trend quite clearly of late, with option traders ramping up the number of bets that would profit should the CBOE Volatility Index rise from its seven-month lows.”
Current sentiment survey readings have also been suggesting that markets are becoming increasingly overbought. “Investor sentiment, which was dismal towards the end of 2011, has begun to reverse and quite rapidly at that,” Stewart points out. The latest sentiment data, indicate almost alarming degrees of optimism and bullish sentiment.
“When the majority of investors have been bullish for some time, we can assume they are reaching levels close to full market participation,” says Stewart. “Once everyone who is going to buy has bought, stocks can be vulnerable to downside corrections. In one of the most recent surveys by the American Association of Individual Investors (AAII), individual investors show the highest levels of bullish optimism since the period leading up to the peak in April 2011, with a ratio of 2,5 to 1 bulls to bears.”
According to Stewart, US financial advisers are equally bullish. The latest survey by the Investors Intelligence Advisors Sentiment shows a ratio of 2 to 1, the highest in the past 12 months, while the National Association of Active Investment Managers’ bulls are at their highest level in 13 months.
Over the past several weeks, short interest on the two major US stock exchanges, the NYSE and the NASDAQ, has also been falling. “The past two weeks alone have seen overall short interest fall by over 5%,” says Stewart. Short interest simply measures the overall exposure short sellers (investors who sell stocks and ETFs short, essentially borrowing shares with the intention of buying them back at a lower price to profit) have to individual securities.
“One may think that this would appear bullish, as fewer investors/traders are willing to bet on profits from the downside, but just like investor sentiment it has often proven to be counter-intuitive,” explains Stewart.
Insider selling has also been accelerating quite rapidly. “While insider selling is normally seen as fairly routine and somewhat random, the rate at which this has been happening of late is neither of these,” says Stewart. “In the month of February alone, as the S&P 500 cleared the 1 320 level, cumulative corporate insiders have unloaded over $2,3 billion in stock while insider buying in that same period totalled only $150 million, amounting to over 15 to 1 sellers to buyers. The acceleration and ratios are similar to those in July 2011, just before one of the harshest two-week periods in the stock market in years.”
The most recent Bank of America Merrill Lynch fund managers survey also saw risk appetite increase rather substantially. According to the survey, global managers upped their weightings to emerging markets from a net 20% overweight in January to a net 44% overweight, which represents the second biggest jump in the past 12 years, following an improvement in expectations for the global economy in the coming year. According to Gary Baker, the head of European equities strategy at BofA ML Global Research, historically such a large shift in sentiment towards emerging markets can be seen as a contrarian trade, with the argument that the sector has got too far ahead of itself.
“Thus far markets have been resilient despite all the headline risk remaining in play,” says Stewart. “With Greece becoming more and more in danger of facing a disorderly default despite the second bailout deal, which could lead to a financial shock throughout the banking system, and concerns regarding the eurozone’s growth, the market has been taking things surprisingly in its stride,” says Stewart.
“The market is due for a period of consolidation,” says Stewart. “While this could materialise as a mere pause before a resumption of the bullish rally, odds still point to some form of a short-term correction before any significant move higher. Therefore, if your portfolio has moved to an overweight equity position due to the strong rise in prices, this may be a good time to trim back your risk to neutral and bank some of your profits.”
Cadiz Street Communications
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