Three Signs Market Sentiment Has Reached Dangerous Extremes

By TradeSmith Research Team

Investors are starting to believe — to really and truly believe — in the power of the Federal Reserve. This is centered around a cluster of assertions:

  • The Federal Reserve will not raise interest rates.
  • The Fed will not let the market go down.
  • Nothing will keep stocks from continuing to rise.
  • Holding equities is as safe as holding cash. 

As the major indices hit all-time highs, various “crowded trades” have almost gone vertical.

Multiple FANG names, for example, have pole-vaulted into trillion-dollar-market-cap land. But it’s not just technology, it’s everything — or almost everything, excluding the beaten-down energy sector.

Utilities and consumer staples, for example, are also displaying “runaway bull market” behavior as evidenced by XLU and XLP, their respective bellwether ETFs. When tech, growth, and stodgy safe havens are all flying at the same time, you know a rising tide is lifting nearly all boats.

The Federal Reserve plays a role here because of their telegraphed actions. They have all but promised not to raise interest rates, which gives the green light to assume risk. And they are likely to rescue the market if stocks tank, creating the perception of downside insurance to the point that holding stocks is like holding cash.

As a result, markets have moved beyond the standard mix of complacency and optimism here, traveling well into the realm of full-blown euphoria.

As a reminder, investors were also euphoric two decades ago, in January 2000. Back then, it also looked like stocks were invincible; and back then the tech sector also dominated.

Except January 2000, as good as it felt, was less than three months from “the end.” In March 2000, the Nasdaq topped out, briefly touching the 5,000 level before entering a bear market for the ages.

It took the Nasdaq 15 years to recover its March 2000 highs. History doesn’t repeat — at best it sometimes rhymes — but this is worth remembering.

And so, for those who pay attention to market sentiment, a few points of interest are quietly alarming.

First, Jason Goepfert at SentimenTrader noted that bullish speculators are breaking records in the options market, and they are doing it with no real hedging activity whatsoever.

Call buying as a percentage of all NYSE volume recently hit an all-time weekly record, Goepfert noted — and then smashed that record in the week that followed.

“The number of contracts being bought to open versus sold to open is skyrocketing,” Goepfert said. This demonstrates lockstep agreement the market can only go in one direction: Up.

As our second point of concern, Rob Hanna from Quantifiable Edges noticed that both the S&P 500 and Nasdaq had both recently closed above their respective 10-day moving averages for 30 days in a row.

If you are familiar with normal price behavior, you will recognize that two major indices closing above their 10-day MAs, in tandem, for 30 days running, is not just “extreme” price behavior. It is far beyond extreme. In probability terms, it’s like a craps roll that runs for two hours straight: Statistically possible, but insanely unlikely.

To see how often this S&P-Nasdaq 30-day streak had happened in the past, Hanna looked at the data going back to 1971. He found just three instances over a 49-year period. And one of them was from November 2019 — that is to say, a part of the current euphoria.

Finally, our favorite euphoria anecdote: A high-profile money manager in Davos said the boom-bust cycle has been repealed.

Bob Prince is the co-Chief Investment Officer of Bridgewater, the largest hedge fund in the world with $160 billion in assets. Prince has very different views from Bridgewater’s other CIO, Greg Jensen, who we wrote about last week.

While Jensen sees gold rising 30% (if not more) and the U.S. dollar’s status as a world reserve currency under threat, Prince seems to think central banks have achieved godlike powers.

“We’ve probably seen the end of the boom-bust cycle,” Prince said in a Bloomberg TV interview.

His argument, from what we could make of it, was that central banks have perfected their skill at managing soft landings, because “lessons were learned” (his phrase) in the last tightening.  

The boom-bust cycle is older than financial markets. Not only that, it is older than money — because credit was invented before money, by way of lending bushels of grain — and it is older than credit, too, because the very first economies based on agriculture and barter experienced boom-bust episodes.

In declaring “the end of the boom-bust cycle” — why not just declare the end of weather? — we can’t figure out what Prince was thinking. His comment was so nonsensical we openly wonder if he was trolling (saying something crazy just for kicks) or deliberately playing dumb to soothe worried clients.

If Prince really believes it — that central banks have beaten the business cycle by “ending” boom-bust episodes — that is the scariest possibility of all. Every so often, Wall Street takes total leave of its senses, and the follow-on results are never good.

When politicians, central bankers, and economic expansions start feeling godlike and invincible — or when investors start viewing them in that light — disaster is typically on deck.

The canonical example of this was economist Irving Fisher’s declaration that stocks had “reached what looks like a permanently high plateau.” Fisher, both famous and respected at the time, uttered those words just nine days before the 1929 stock market crash.

We sincerely hope Bob Prince was joking. If he wasn’t, then position sizing and risk management — along with downside protection strategies, via the help of investment software like TradeStops — will be more crucial than ever in securing a safe retirement.

TradeSmith Research Team