Sentiment signals

Sentiment signals

Investing successfully is rarely easy. The current market environment is making a tough job tougher. The interplay between the outlook for growth and potential central bank action means predicting market moves after the release of new information is particularly difficult. The subsequent moves are more usually a reflection of investor sentiment rather than economic fact.

On 26 April this year the advance estimates of first quarter US GDP growth surprised investors. The economy expanded at an annual rate of 3.2%, well above estimates centred on 2.3%. The S&P 500 index rose on the day, and lifted further over the following sessions as analysts and investors factored higher growth into their assumptions.

Compare this to the reaction the advance estimates of third quarter US GDP growth on 30 October. Again, the advance reading at 2.1% pa was ahead of consensus at 1.8%. However this time the share market began a five day fall that wiped 180 points (about 6%) from the S&P 500 index. The better growth prospects hurt the market as participants focussed on the potential for the US Federal Reserve to delay rate cuts and other supportive actions. 

These vastly different market reactions to pro-growth surprises illustrates the difficulties investors face.

The rise of algorithmic trading is just one manifestation of attempts over the past five decades to improve the science of investing. Humans prefer certainty, and a robust, quantitative approach has intuitive appeal. The problem is that there is not a mathematical model in the world that can explain the opposing market moves described above.

One approach to deal with the current environment is to employ more tools based on the art of investing. Sentiment and positioning are important in determining market direction when the interplay of fundamentals and monetary policy muddies the water.

Active investors could do well to doubt the extremes of sentiment.

In July and August a soft patch in data from Europe, China and the US saw a number of analysts forecasting a global recession in 2020. The trade disputes provoked by the US were at their heights, and economists were busy working out just how much tariffs would shave from national and global growth estimates.

Naturally, stocks sold off. Sentiment was extremely negative. The point at which a majority of market participants agreed recession was on the cards was close to the low point of share market indices.

At the moment the majority view is that the US and China will reach a phase-one trade deal very soon. This optimism runs counter to experience over the last twelve months, when repeated positive comments failed to deliver any meaningful results. Nonetheless share markets are trading at multi-year or all-time highs.

A recent Bank of America / Merrill Lynch survey of professional investors showed the biggest upswing in sentiment in ten years, and that a majority expected equities to be the top performing asset class in 2021.

It’s easy to form the view that market sentiment is once again at an extreme, and therefore a potential turning point. This is not an economic prediction, it’s about near term market direction.

The good news for those who refuse to look at the fuzzier predictive tools is that there are numbers to back up the potential for a sharp correction. Taking the S&P500 as an example, valuation ratios look stretched. The one year forward  Price to Earnings ratio is around 19 times, close to the ten year high around 20 times. The Price to Book and Price to Sales ratios are also at or near ten-year highs. While each of these ratios is only a rough guide, the combination of all three at extremes supports a view that a correction is potentially imminent.

Predicting the future is always uncertain, and the market makes fools of us all at some stage. Understanding the current drivers of a market is a crucial contributor to getting more investment decisions right. Doubting extremes of sentiment is powerful under current market conditions.