December 7-10, 2020: market thoughts

The following is my stream of thoughts. This webpage will be continuously updated throughout December with new insights.

December 10, 2020

Sentiment

Nothing changes sentiment like price

It’s been an incredible 9 months for the U.S. stock market, with U.S. indices mostly going in only 1 direction – up. Since sentiment and price rarely move in opposite directions, the stock market’s rally has pushed several sentiment indicators to extremely high levels. As you’ve probably heard of by now, traders are buying call options like there’s no tomorrow. The CBOE Equity Put/Call ratio is near its lowest level in nearly 2 decades:

The Equity Put/Call ratio’s long term average has changed over time. To account for this generational shift, we can instead look at the Equity Put/Call ratio’s 10 dma vs. its 200 dma:

Such extreme sentiment over the last 15+ years only occurred in 2010 and this year (both after a recession & bear market). The 2010 historical case was immediately followed by a major correction. But record call buying this year has not dented the stock market’s rally thusfar (i.e. it was not a timely SELL signal):

I calculated a 10-factor Medium Term Sentiment indicator to better gauge sentiment in the U.S. stock market. As you can see in the chart below, sentiment is elevated, but not as elevated as it was before stocks pulled back in September-October:

A closer look at the past few years reveals that stocks can continue to rally a little more despite such extreme sentiment, but a pullback/correction usually was not far off in the distance.

Meanwhile, plenty of market watchers have called for a USD bottom this year, but to no avail. The U.S. Dollar continues to grind lower, pushing its Short Term Sentiment’s 200 dma to the lowest level in years.

Like other mean reversion indicators, sentiment is not always an effective contrarian indicator, particularly in markets that exhibit strong momentum-characteristics. Currencies and commodities are one such market. Extreme sentiment in currencies and commodities can often get even more extreme due to strong trends that can occur in these markets.

When the U.S. Dollar Index’s sentiment was this pessimistic, the U.S. Dollar usually continued to fall over the next 2 months before finding a bottom:

The non-stop barrage of pandemic-related news dented news-related sentiment this year. But with a major vaccine rollout just around the corner, news-related sentiment is improving. The San Francisco Fed’s Daily News Sentiment Index has rallied back to zero (neutral sentiment) after plunging during the global lockdowns in March. Description for this indicator:

The Daily News Sentiment Index is a high frequency measure of economic sentiment based on lexical analysis of economics-related news articles.

Improving news sentiment was usually a good sign for stocks over the next 3 months. Perhaps this is due to more optimistic media coverage influencing readers’ biases, making readers more optimistic towards the macro landscape as well. The one major historical exception was in March 2002, when the recession was already over yet stocks continued to fall:

December 9, 2020

Breadth

Many analysts were worried a few months ago because “breadth is weak” (there’s always something to “worry” about). Now that previous laggards such as value stocks, energy stocks, and financial stocks are catching up, such worries are dissipating. Breadth is improving, and the % of S&P 500 stocks above their 200 dma (in a long term uptrend) is at its highest level in years:

Source: StockCharts

Such strong breadth, like such strong momentum, can lead to a short term pullback. However, in the long term it led to more gains for the broad S&P 500:

NASDAQ data paints a similar story: with the % of NASDAQ Composite stocks at one of the highest levels ever:

Source: StockCharts

This was consistently bullish for NASDAQ stocks going forward:

More momentum

Tech’s rally isn’t stopping. Despite many analysts’ concerns earlier this year that “tech was the only thing lifting up the stock market”, the tech rally continues. Stocks which recently IPO’ed are on fire, and the NASDAQ 100 is up 10 days in a row.

In the past, such strong momentum almost always led to more gains for the NASDAQ 100 for the next 9 months:

The stock market is a tug-of-war between momentum (trend following) vs. sentiment (contrarian), and thusfar momentum is winning.

December 8, 2020

Economy

While valuations remain a major long term concern for global stock markets, a major tailwind is the global economy. The global economy will most likely improve as vaccines rollout and government stimulus mutes the worst of the pandemic’s fallout. This is a very unique situation in that it has never happened before: a post-recession economic expansion that BEGINS with high valuations.

To illustrate the point that the improving economy is a long term tailwind for stocks, the following chart demonstrates that earnings estimates being revised upwards:

As you can see, such strong revisions are common at the start of major bull markets as conditions improve and analysts chase the news. (The 2017/2018 earnings boost was unique in that it was mostly caused by Trump’s tax cuts). The following chart maps the S&P 500 against global earnings revisions:

*earnings revision charts from Yardeni

While an improving economy is a long term bullish factor for stocks, it is not very important in the medium term. Post-recession economic expansions are usually followed by massive stock market rallies, and then a multi-month consolidation period in which the market realizes high volatility. That is my base case going into 2021.

To illustrate this point, the U.S. unemployment rate has probably reached its highest level during this recession.

When the Unemployment Rate peaked 7 months ago, much of the S&P 500’s gains were already over. In other words, by the time the economy improved (i.e. now), MOST of the gains had already been booked and future returns were not as bullish as past returns:

December 7, 2020

Momentum

2020 has been one hell of a year. After global equity markets surged in January, the pandemic and ensuing lockdowns caused stocks to crater. Record government stimulus and vaccinations created a risk-on environment in which ALL major risk assets are rallying: stocks, commodities, real estate, ex-U.S. currencies, etc.

The following chart illustrates the average 180 day % change of 10 stock markets and 4 commodities markets.

  1. Stock indices from the world’s 10 biggest stock markets: U.S., Japan, Germany, Canada, Australia, UK, China, India, South Korea, France
  2. Commodity prices: crude oil, natural gas, copper, sugar

Such strong across-the-board momentum is how multiple bull markets in the past were started. For example, this occurred at the start of the 1990s bull market, at the start of the 2003-2007 bull market, and at the start of the 2009-2020 bull market. It also happened in 1999 after a major scare in 1998. Back then, stocks roared for another year before topping.

Here’s what the S&P 500 did next under less extreme cases:

As you can see, this was more bullish for stocks than it was for commodities. The next table illustrates what the CRB commodities index did next:

Incredibly strong momentum can lead to short term pullbacks and corrections (nothing lasts forever), but is usually followed by higher highs.

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