Market Sentiment Gaining Momentum

We’ve completed our eighteen-month audit for our Trading Fund. Since (July 2015) we are up 29.1% gross return. We trade primarily large cap US equities that reside in the S&P 500. Using this index as our benchmark, the S&P 500 was up 5.2% during the comparable period.

Market Sentiment

Post-election, market sentiment and economic expectations are really picking up momentum. From Business Insider, “The final January reading of consumer confidence from the University of Michigan came in higher than expected. The reading on US consumers' outlook was 98.5, better than the 98.1 expected by economists. This was also above the initial reading of 98.1 earlier in the month.”

“Consumer confidence has surged in the wake of the US election, as improved outlooks for growth and jobs have bolstered the index.

"Consumers expressed a higher level of confidence January than any other time in the last dozen years," said Richard Curtin, the survey's chief economist. "The post-election surge in confidence was driven by a more optimistic outlook for the economy and job growth during the year ahead as well as more favorable economic prospects over the next five years."

Curtin did caution that the current boost in confidence comes from expectations and not actual improved circumstances. "Overall, the post-election surge in consumer confidence was based on political promises, and not, as yet, on economic outcomes," said the press release.”

“According to Curtin, consumers are actually borrowing more in anticipation of interest rate hikes from the Federal Reserve. Increasing inflation expectations have led the Fed to raise their expectations for the number of interest rate hikes in 2017.”

We see this divergence between expectations and actual data with the latest durable goods orders from the Commerce Department falling short of expectations and the tepid 4Q16 GDP figures.

Small business optimism has surged post-election on expectations of brighter days ahead.

According to Calafia Beach Pundit, “Small businesses, who employ 48% (57 million) of all private sector employees, are apparently feeling MUCH better about the future, presumably because they believe that President-elect Trump will be good for business. Regulatory and tax relief such as Trump promises would almost certainly result in more investment, more jobs, and more growth.”

“As the chart above shows, consumers are also feeling better these days. According to the Conference Board, consumers are more confident today than at any time since the current recovery started.

All of this is crucial and augurs very well for stronger—perhaps much stronger—growth in the years to come. Confidence has been sorely lacking during this recovery, and it shows in the lackluster growth of business investment, as seen in these charts:”

Tracking fund flows is another way we track market optimism. As seen from the ICI fund flows data, equities as a percent of total assets is roughly 52%. At the start of the past two bear markets, market euphoria was much higher than it is today as measured by equities as a percent of total assets. The number that we look for is 55% exposure to equities as a sign that market sentiment is running full steam. This means there is quite a bit of money out there that can be rotated into equities providing the fuel higher.

The Fat Pitch blog goes further on the asset allocation. “Among the various ways of measuring investor sentiment, the BAML survey of global fund managers is one of the better as the results reflect how managers are allocated in various asset classes. These managers oversee a combined $500b in assets.

The data should be viewed mostly from a contrarian perspective; that is, when equities fall in price, allocations to cash go higher and allocations to equities go lower as investors become bearish, setting up a buy signal. When prices rise, the opposite occurs, setting up a sell signal.”

“Fund managers' cash levels dropped from 5.8% in October to 5.1% in January; cash is up slightly from December. Recall that 5.8% was the highest cash level since November 2001. Cash remained above 5% for almost all of 2016, the longest stretch of elevated cash in the survey's history. Some of the tailwind behind the rally is now gone but cash is still supportive of further gains in equities. A significant further drop in cash in the month ahead, however, would be bearish.”

“Fund managers were just +5% overweight equities at their low in February 2016; since 2009, allocations had only been lower in mid-2011 and mid-2012, periods which were notable bottoms for equity prices during this bull market. Allocations in January have jumped to +39% overweight, a 13-month high. This is now slightly above neutral (0.4 standard deviation above the long-term mean). Over +50% overweight has historically been bearish (dashed line).”

“In February 2016, 16% of fund managers expected a weaker economy in the next 12 months, the lowest since December 2011. They are now optimistic: 62% expect a stronger economy in the next year, a 2-year high. Pessimism explained their prior low allocation to equities and high allocation to cash; that has now changed.”

“US exposure had been near an 8 year low during the past year and a half, during which US equities outperformed. US equities have been under-owned. That's changed. In January, fund managers were +14% overweight (the same as last month). This is 0.9 standard deviations above its long-term mean. Bearish sentiment is no longer a tailwind for US equities. Above +20% overweight and sentiment would become a headwind (dashed line). Close, but not yet.”

Bottom Line: The market sentiment picture is improving at a brisk pace. Whether economic realities can live up to expectations remains to be seen. We are cautious in our outlook but understand “animal spirts” is a powerful market force that will propel the market higher.

Joseph S. Kalinowski, CFA