Conflicting Signals – What to Make of Extreme Optimism and a Strong Trend

Time to Read: 8 minutes

At Stratos Private Wealth, we believe you can assess how the market should be acting by looking at a combination of macroeconomic conditions and fundamentals. Over the long run, the market generally does what it should. But, as noted by famed economist John Maynard Keynes, the market can remain irrational longer than you can remain solvent. For this reason, we also consider sentiment and technical analysis, which describe how the market is acting. Together, these assessments help guide our tactical investment decisions.

Macroeconomic and fundamental indicators look clearly bullish

When we look at macro and fundamental data, the message seems clear. The charts below illustrate the economy as represented by the Conference Board Coincident Economic Index and the ISM Manufacturing Purchasing Managers Index (PMI). The PMI readings are well into the “expanding economy” zone, reaching the highest levels seen in decades as the US economy continues to climb out of its COVID-related recession. These readings are very bullish for the economy and markets.

Sentiment and technical indicators are less supportive

Our sentiment and technical indicators are more nuanced. Investor optimism is near multi-year highs and, technically, market breadth is the strongest it has been in years. As the S&P 500 continues to hit record highs, more people are investing cash that was previously on the sidelines. In fact, equity fund flows recently hit their second-highest level on record, as shown below.

As you might expect, these moves are registering excessive optimism. We track the NDR Daily Trading Sentiment Composite, which is currently near its highest level since January 2020 and well into the “excessive optimism” zone, as shown below. As the performance table in the lower right portion of the chart illustrates, the S&P 500 has tended to underperform when investor sentiment has been so optimistic.

Don’t fight the trend

One of our foundational beliefs is “don’t fight the trend.” Since the March 2020 low, the trend has been an impressive upward climb. One way we measure momentum is through breadth thrusts, which occur when an extremely high percentage of stocks rally together over a short period of time. After breadth thrust signals are seen, problems in a few stocks typically aren’t enough to derail the popular averages because so many other stocks remain in uptrends.

Breadth thrusts are common at the beginning of bull markets because many stocks are deeply oversold. They were plentiful in the weeks following the March 23, 2020 low, which helped reinforce our increase in equity exposure at that time. Perhaps even more remarkable was a breadth thrust on February 12, 2021, almost a year after the March 2020 low! This was surprising given it came after a modest 3.7% drop in the S&P 500. The chart below illustrates these signals alongside index performance.

Mixed outcomes ahead?

We’re currently seeing two key rules standing in opposition: On one hand, excessive optimism is historically bearish. On the other hand, strong breadth is historically bullish. When this has happened in the past, the outcomes have been mixed until one of the two forces has given way.

The table below shows the gain per annum for the S&P 500 when the NDR Daily Trading Sentiment Composite has been in the “excessive optimism” zone as well as the market return after a breadth thrust. The S&P 500 has fallen at a 3.4% annual rate under extreme optimism but has surged at a 18.5% rate following breadth thrusts. As such, the signals are conflicting. When both conditions have been simultaneously met—a situation that occurs only 10% of the time—the S&P 500 has basically been flat, falling at a 0.5% annualized rate. In other words, our rules cancel each other out.

Notably, the current situation is showing signs of extreme optimism: With a reading of 76.7, the sentiment indicator is in zone it rarely reaches. So, what has historically happened when crowd sentiment has a reading above 70, combined with a breadth thrust? The S&P 500 has fallen at a 7.4% annual rate, as shown below.

Before we get too bearish, it’s important to realize this combination of sentiment and breadth has been rare, occurring only 5.5% of the time since 1980. With so few cases, we view this as more of a tendency than a statistical certainty. For example, during the 1990s, the S&P 500 managed to rally at a 7.8% annual rate when sentiment was above 70 and breadth thrusts were signaled.

How should investors react?

For clients following a dollar-cost averaging strategy, we already use the NDR Daily Trading Sentiment Composite as the basis for how much to invest. Far less cash is put to work in weeks where sentiment is optimistic vs. weeks when sentiment is pessimistic.

Additionally, we don’t think portfolios should be adjusted in an effort to anticipate a pullback. Rather, we would use a pullback to assess the health of the current market. A short correction that relieves excess optimism but still maintains good momentum would set up buying opportunities based on a belief that it should be a normal pullback within an ongoing bull market. If the pullback also sharply deteriorates breadth, it could be setting up for a deeper correction, which could warrant cutting our current overweight to equities. We’ll be watching our objective indicators in the coming days and weeks to see how this dynamic unfolds.