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The chief investment strategist of a $7.6 trillion firm breaks down how euphoric investor sentiment is making stocks vulnerable to a potential ‘full-blown 10% plus correction’ — and lays out 3 ways investors can protect against losses

  • Even though stocks have already bounced back from Monday’s losses, risks abound in the market.
  • Euphoric investor sentiment particularly renders stocks vulnerable, Schwab’s Liz Ann Sonders says. 
  • The chief investment strategist explains why and shares 3 ways investors can protect against losses.
  • See more stories on Insider’s business page.

It probably comes as no surprise that when the Dow tumbled more than 700 points on Monday, investor sentiment was firmly rooted in the “extreme fear” territory. 

But Charles Schwab’s chief investment strategist Liz Ann Sonders has seen this too many times before. She knows that attitudinal measures of sentiment can change on a dime, and it is the actual investor portfolio positioning that exposes where the real risk lies.

“What you say and what you do are two different things,” Sonders said in an interview. “But it’s the positioning, things like household equity exposure at near an all-time high, that’s where the risk is greater because there’s just more to potentially unwind if this thing starts to feed on itself.”

Despite suffering from its worst day of the year amid Delta variant concerns, the Dow’s Monday swoon quickly transformed into a full-on rally come Tuesday.

However, the rebound may be short-lived. By several metrics, investor sentiment is getting euphoric to extent that stocks could be vulnerable to a potentially full-blown correction

“Would it surprise me to see the S&P, the Nasdaq, and the Russell or some combination of them finally have a full-blown 10% plus correction? No, it wouldn’t surprise me at all,” she said. “We’ve got most of the stimulus in the rearview mirror and the Fed is looking to rein in

liquidity
. That just means, regardless of what happens, we are arguably in a trickier part of the market cycle where a lot of the easy money has been made.”

2 categories of sentiment indicators flashing warnings 

Sonders likes to explain the importance of tracking investor sentiment by invoking the famous words of legendary investor Sir John Templeton: “Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.” 

“I think there’s never been something more brilliant said about the market than that,” she said. “If everybody is wildly optimistic, especially if they are not just saying they’re wildly optimistic, but they are positioned in a wildly optimistic way, there’s not a lot of excess fuel to power the market higher, because everyone’s in.”

Investor sentiment works equally well when greed turns into fear.

“In March 2009, everyone is just at an utter extreme of despair,” she said. “They are probably out or have sold or not sitting on large positions. And there’s the fuel for the move higher, so that’s just the connectivity to what actually goes on in the market.”

If tracking investor sentiment is an easy feat, then everyone would be front-running the stock market. Sonders looks at a broad array of sentiment indicators that can be categorized into economic and investor sentiment indicators. 

Economic sentiment indicators such as the Conference Board’s Consumer Confidence Index and CEO confidence survey have gone back to pre-pandemic territory and reached record highs, respectively. 

Investor sentiment indicators, which include both attitudinal and behavioral measures, have also reached elevated levels. For example, US households’ allocation to stocks, a key behavioral metric, has almost reached the level last seen in the times leading up to the dot-com bubble, as shown in the chart below. 

 

US household exposure to stocks



Charles Schwab


The continued surge in call options volumes and inflows into exchange-traded funds also signal that investors are positioned in an extremely optimistic manner, according to the charts below. 

call options volumes surging in 2021



Charles Schwab


surge in ETF inflows



Charles Schwab


Not all sentiment indicators are flashing signs of euphoria. For example, SentimenTrader’s Smart/Dumb Money Confidence indicators, which track and compare the positioning of smaller day traders (so-called dumb money) and commercial hedgers, big players in the index and futures market (smart money), are not yet at extremes. 

Sonders believes that it’s important to look at a collection of indicators to see if there are universal patterns across the board or divergences in sentiment that are starting to creep in.

Mini pockets of correction and 3 guards against losses

Besides the economic and investor sentiment indicators, sentiment can also be gauged in non-traditional pockets of the market such as cryptocurrencies and meme stocks

“You’ve seen 30% to 60% declines in these little mini pockets of the market,” Sonders said. “When people say how come the markets are so resilient given sentiment is so stretched, well, where sentiment has been most stretched, those pockets of the market have not been resilient, they’ve had massive 50% haircut kind of declines.”

Whether those massive declines will spread into the traditional market environment is hard to predict, but investors should prepare for more volatility ahead. 

To that end, Sonders has been offering three pieces of advice to her clients: (1) don’t have all your eggs in one basket, be diversified, (2) heed the benefits of periodic rebalancing which can force you to trim outsized positions and take profits, (3) be more factor-focused than either sector- or style-focused

Currently, Sonders’ team only rates healthcare as “outperform” because she believes that there are “value stocks” in typically growth sectors and growth stocks in traditionally value sectors. 

“I think you want to be value-minded but that doesn’t mean just blindly buy one of the value indexes,” she said. “You can screen for reasonable value so that you are not paying ridiculous valuations for stocks, you can do that and still get growth characteristics.”

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