In this market commentary, we are going to discuss two potential issues that the markets are facing right now. The bottom line is that the markets are vulnerable and could become risky. Here are the two issues that are going to be covered in this update:
· A few large names are masking market weakness.
· Investor sentiment is at a high. That means investors are optimistic. This is a contrarian indicator.
Before we get started discussing the two topics at hand, let’s have a quick note on volatility. For most all of 2023, volatility has been declining from the high levels seen last year. Declining volatility is a positive for the markets. That said, we know that volatility can be too high, but it can also get too low.
Regular readers of our market commentary will recall our discussions of “outlier days.” An outlier day is any trading day that is beyond +/-1.50%. In short, we arrive at this “1.50%” threshold by examining the market’s daily standard deviation during a normal, efficient “bull” market environment. During normal market environments, you can expect that the S&P 500 would experience roughly 5 out of a 100, or 10-20 outlier days over the course of a year (250 trading days).
It has been a while since the market has experienced an outlier day. The market’s last outlier day occurred 33 trading days ago. This has been the S&P 500’s longest streak without an outlier day since September 2021. When volatility gets too low, it can be similar to the squeezing down of a spring- eventually the market will need to relieve some pent-up pressure. The release of pressure can occur in either direction and will most likely come in the form of “outlier days.” When you combine a very low volatile environment with the next two issues left for discussion, it puts the market in a vulnerable position that could lead to a selloff.
The first major issue that the market is facing is weak market breadth. The market has a few large stocks going up, and a lot going down or moving sideways. We have covered this quite a bit in our last few market commentaries but feel that it is a point that needs reiterated. A few of the market’s largest names and biggest components are masking how weak the market is becoming.
Many indexes like the S&P 500 and Nasdaq 100 are capitalization weighted. This means that larger stocks, like Apple, Microsoft, Google, Amazon, etc. will have a greater impact on those index’s price value. So far this year, larger technology-oriented names have vastly outperformed the rest of the market’s components.
Look at the chart below, which shows the Advance-Decline Line. This line measures market breadth, or the number of stock issues increasing versus decreasing. While the market has trended higher over the last few months, market breadth has declined. This means that a few larger capitalized stocks, like the few mentioned above, are pulling the market higher, but the majority of individual securities are falling off.
Chart Source: Canterbury Investment Management. Created using Optuma Technical Analysis Software
We are not the only investment firm noting the lack of market breadth. The Colby Global Markets Report also writes:
“Until last week, the indicators had been reflecting strength for a few big-cap technology stocks but bearish divergencesfor the great majority of common stocks. The stock market is not nearly as strong as the large-cap weighted S&P 500 and Nasdaq 100 indicate. This is a very big problem and a clear warning that the stock market is not on a firm foundation.” -Colby Global Markets Report, June 23rd, 2023.
Technology-related stocks were the worst performers during last year’s bear market. This year, they have been some of the best, to a point of exuberance. The danger is that parabolic curves can change quickly. With Tech’s overweighted impact on the market, and the rest of the market being generally weak, a decline in technology stocks could lead to an increased sell-off in the general markets.
We just referenced a quote from the Colby Global Market Report. Another subject that their report made note of was market sentiment. Over the course of the past few months, market sentiment has shifted from the majority of investors being bearish to the majority of investors being bullish. Colby points out that CNN’s fear and greed index has floated between greed and extreme greed over the past few weeks and as the market has increased, underinvested portfolio managers have been forced into it to avoid the Fear of Missing Out. Historical evidence shows that high levels of optimism precede market declines, while high pessimism often precedes rallies.
In other words, investor sentiment is a contrarian indicator. The markets will often do the opposite of what the majority expect them to do. Supply and demand will experience periods of extremes. If everyone is bullish, then it means that everyone is already invested, and there aren’t many investors left to buy and push prices higher.
The sentiment indicator that we often look at comes from the American Association of Individual Investors Sentiment Survey. The survey is released weekly and gauges its participants’ opinions on where they think the market will be in the next six months. Participants indicate whether they are “bullish,” “bearish,” or “neutral” on the market.
In the June 15th survey results, bullish sentiment was at its highest level since November 2021. Bearish sentiment was at its lowest level since July of 2021. In other words, this is the most positive investors have been on the markets in almost two years. The last time the market was this “bullish” was right around the peak in the Nasdaq 100’s peak in 2021, prior to a bear market.
The chart below shows the AAII Sentiment Survey results around various peaks and troughs in the last year and a half. Notice that at each trough, bearish sentiment is very high and bullish sentiment is very low. On the contrary, at the peaks, bullish sentiment rises, and bearish sentiment falls, prior to another market decline. Now, bullish sentiment is at its highest level, while bearish sentiment is at its lowest level.
Source: Canterbury Investment Management. Chart created using Optuma Technical Analysis Software. Sentiment data comes from AAII Investor Sentiment Survey.
Let’s Tie It Together
Here is the sum of the issues presented in this commentary. You have a few larger stocks that have carried the market higher, and in many cases, gone parabolic while the majority of stocks have meandered around or declined. The exuberant nature of these few large stocks has caused many investors and managers alike to flood into the markets to avoid the fear of missing out. This has pushed the markets higher and caused investor sentiment to continue to rise.
As buyers come into the markets, and into particularly, the already overinflated technology stocks, eventually there are very few investors left to buy and raise the demand for stocks. Perceivably, there would be more potential sellers than new buyers. With where the markets were in 2022 and with some negative outlooks from economists for the second half of 2023, an influx of volatility could create a wave of selling as investors panic and attempt to avoid losses.
Markets are not predictable. Just look at the sentiment survey. They will often go against what the majority expects. That being said, we can analyze the markets’ current trends and characteristics and determine the probability of something happening. Right now, the market is vulnerable, and the probability of a pullback or decline is higher. If a decline does occur, no one will know the timing of it, nor the extent.
At Canterbury, we practice adaptive portfolio management. This means that we rotate positions and adjust asset allocation to deal with the current market environment. We are not trying to make predictions but will move in concert with changing market environments.
Right now, our adaptive portfolio strategy- The Canterbury Portfolio Thermostat- has exposure to those sectors that have performed well, like technology stocks and homebuilders. We also have defensive positions in alternatives or “inverse” that move in the opposite direction of their underlying components. These could be inverse positions in weaker market sectors like financials or real estate. As market conditions change, the portfolio adapts. The goal is to limit the portfolio’s volatility for whichever market environment comes next- bull or bear.