FYI | Jan 18 2011
By BTIG chief market strategist Mike O'Rourke
(This story was originally released to BTIG clientele on January 12).
Over the past several days, we have been asked numerous times about the high level of bullish sentiment among investors and its bearish implications for equity investors. Most readers of this note are aware of how closely we track sentiment data, especially the American Association of Individual Investors (AAII) data, which is released every Thursday. Likewise, many readers know that we have our own formula for interpreting the data. The BTIG calculation is a bit complicated so instead tonight, we are going to speak in terms of the headline numbers that AAII releases. The concern among investors emanates from the fact that AAII's Bullish sentiment is 55.88% and Bearish sentiment is 18.25%, making the spread between the two numbers 37.63. With the exception of Christmas week (3 weeks ago), which had a spread of 46.9 (63.3% Bulls, 16.4% Bears) the current spread is the highest since late 2005/early 2006. In the overwhelming majority of cases when bullishness becomes pervasive, it is prudent and appropriate for investor concern to rise. We believe, however, that 2010-2011 is one of those rare exceptions and investor bullishness is appropriate, and is a likely precursor of additional gains.
We will briefly digress to discuss the fundamental economic scenario because it influences sentiment. Throughout the past couple of years, we have modeled the Recession and the recovery based upon previous recessions and bear markets. Generally, we measured against 1973-1975 and 1981-82, since they are the previous worst post-war recessions. The 2001 recession and the 2000-2002 bear market was an anomalous event but the recovery in 2003 exhibits similar characteristics to today's environment. One key parallel is that the Unemployment Rate remained at a plateau level near its peak for 18 months or more. This is distinctly different from previous recessions where Unemployment tended to trend higher until the peak and then almost immediately began trending lower. We believe such Unemployment plateaus prompt even bullish investors to keep one foot on dry land, even if equity markets and other metrics begin to recover. To date, mutual fund flow data has indicated this is the case with this recovery. Remember, despite that extreme bullishness last month, domestic equity mutual funds experienced big outflows. Investors are not truly ready to jump in the pool until the data begins to indicate the recovery is taking hold and that Unemployment Rate is set to begin its descent.
It was 2003 when the Unemployment Rate peaked and commenced its descent earlier in the decade. The peak for Unemployment during this cycle is 10.1% in October 2009, but few would call the improvements since then a descent. We perpetually focus upon Initial Jobless Claims because when they are declining in a recovery, equities are usually rallying. Chart 1 below depicts the improvement of Initial Jobless Claims and the percent change in the S&P 500 from the start of 2003 through early 2004. Chart 2 is the same except that it starts at the beginning of 2010 and runs through today. In both cases, when Initial Claims begin declining, the S&P 500 rally continues steadily. One key difference here is that April 2003 was the peak in Initial Claims for that cycle, but this cycle's peak occurred in March of 2009. Where we expect a parallel is that both of the moves were the ones that preceded a decline in the Unemployment Rate. As we know, since August, Initial Jobless Claims have dropped by more than 100,000, and they remain on track for additional improvements in 2011. We suspect that in August, a phase similar to April 2003 commenced.
Returning to sentiment, late 2010/early 2011 appears to be very similar to the 2003 scenario. Chart 3 below illustrates the AAII Bulls and S&P 500 gains for 2003. One will notice that the level of bullishness was high throughout most of the year. The average level of bullishness from May through January 8, 2004 (37 weeks) was 56%. Remember, today's level of concern is 55.88%. Chart 4 is the same but instead depicts bearishness. The average level of bearishness from the start of May 2003 though the first week of January 2004 was 21.5%. One can see that despite the persistent bullishness and minimal bearishness, the 2003 equity rally was undeterred. The bullishness was for the right reasons and people were still out of position. In the respective charts, we overlaid the 2010 level of bullishness and bearishness. What that shows is that we are only just now starting to hit the levels of optimism that were reached in May and June of 2003 and persisted into early 2004. Earlier we discussed the spread between bullishness and bearishness, which is 37.63. In the 26 weeks between August 21, 2003 and February 12, 2004, there were only 8 weeks where the spread was tighter than 37.63. During that 6 month time period, the S&P 500 rose 15%. Sentiment is bullish now, and it is likely to get more bullish. This is probably the rare scenario where the crowd is correct.
The views expressed are O'Rourke's, not FNArena's (see our disclaimer).
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If you are reading this story through a third party distribution channel and you cannot see the charts included, we apologise, but technical limitations are to blame.
