What Can Possibly Go Wrong?

“Wet sand makes for a better sandcastle
Inhale, exhale, just take a breath
I know that things don’t always happen like they should
Gotta learn to roll with the punches
And just say it’s all good”

NE-YO & Cher Lloyd – “It’s All Good”

Apparently, nothing can. At least that is the impression we get from various sentiment and positioning data relating to the stock market and risk assets more generally.

Below we show a number of pertinent charts of both short and long term indicators. Note here that as always, not every sentiment and positioning indicator is locked at an extreme. In fact, there are subtle divergences visible in several of them.

For instance, net long exposure according to the NAAIM survey is “only” 75%, which is down from a the record 104% of late 2013, as well as down from some of the reading we have seen since. Note however that the admittedly short history of this indicator shows that the net exposure of the fund managers surveyed tends to peak well before the market gets into trouble.

Anyway, similar small divergences usually occur in other indicators as well, such as total margin debt, a variety of sentiment surveys, volume put-call ratios and so forth.

We do however have a new weekly record high in the Rydex bull/bear asset ratio – currently 18.6 times as many assets are in bull and sector funds than in bear funds. However, even in this complex of data there is a subtle divergence visible. Bear assets have for instance collapsed again, but remain slightly above the record low recorded earlier this year. The same goes for money market assets, which have recently seen a sharp decline, but have failed to fall back to the 17 year lows seen earlier this year.

First a look at the Investor’s Intelligence Poll. Apparently, the recent two week rise in the poll’s bullish percentage was the biggest in at least 20 years. We actually believe it is even more remarkable that the market bottomed in mid October with bears at just 17.3% – this percentage is now back to just a tad above 15%.

The Investor’s Intelligence Survey: Nothing can go wrong …

An illustration of the two-week jump in the bull ratio using the most recent data point by sentimentrader. As can be seen, previous big jumps in this percentage didn’t necessarily mark market peaks – unless they did. Since the current jump is probably one of the biggest ever and goes hand in hand with a complete dearth of bears, it may not be business as usual – especially as the current bubble is already one of the biggest in history (depending on which way its relative size is measured, it is somewhere between the top spot and third place)

Next a chart of various Rydex data. This group of traders remains positioned very similar to 1999/2000. While Rydex traders were uncommonly cautious during the 2002-2007 bull market, they are currently anything but. 

The Rydex bull-bear asset ratio (in purple) reaches a new all time high – it is once again above the year 2000 peak level

Next, a look at the above mentioned NAAIM survey, which as noted still displays a subtle divergence with prices.

Fund managers interviewed for this survey are currently 75% net long on average (responses can range from 200% net short to 200% net long, with the record high average net long position of 104% recorded in late 2013. Note that as a group, these managers have been slightly net short in only three weeks in the survey’s history) 

Long Term Indicators

The indicators above are mainly of short to medium term significance. What about longer term indicators though? Overall, there has never been more complacency in the markets than at present. These indicators are not helpful in timing the market, but we believe they are helpful in gauging how risky the market is. In other words, they are saying something about the potential size of future losses (and possibly also about the duration of the next cyclical bear market, but that is of course something that remains to be seen).

The Fed’s financial stress indicator, which should perhaps be renamed the non-stress indicator. Once again, the available history is fairly short, but it does show that there have been two periods when perceptions about risk were at an extreme of complacency. So far we only know what happened after the first one 

The next indicator has a very long history indeed. It is the percentage of mutual fund cash vs. assets. However, its message cannot be taken at face value. First of all, how popular cash holdings are with fund managers partly depends on whether they can actually get some interest on said cash. Secondly, there has probably been a shift in general attitudes toward the amount of market exposure a mutual fund is expected to hold. Nevertheless, the extremely long period of ultra-low cash levels does look like a mirror image of what happened prior to the beginning of the last secular bull market in 1975 (or 1982, in real terms). The low level of cash also means that funds have no firepower to buy if the market declines – rather, if/when funds are hit by redemption requests, they will be forced to sell.

The mutual fund cash percentage since the mid 1960s

Lastly, here is a look at margin debt, and net investor credit. It is noteworthy that although margin debt drifted higher again in September, it remains slightly below its all time high.

Similar to the last two bubble periods, it has experienced a phase of extremely rapid growth in recent years. However, net investor credit has reached new all time lows – which is a mirror image of the situation at the 2009 low – i.e., it is at the 180 degree opposite position now.

Margin debt, total vs. the SPX in real terms (i.e., CPI adjusted), via Advisor Perspectives

NYSE investor credit – another indicator at an extreme. Stock indexes are at a record high, but investor net worth has never been more deeply in the red. This makes the market vulnerable if a decline goes beyond the pain threshold suggested by this large amount of leverage.

Here is a very long term chart of NYSE investor credit, which shows that such extreme run- ups in margin debt are a relatively new phenomenon – in fact, they are a typical characteristic of what we would term the “bubble era”:

NYSE investor credit since the mid 1960s – huge run-ups in margin debt are a relatively recent phenomenon. The current negative record in cash available to investors is evidently in a class all its own – click to enlarge.

Conclusion:

If any of this worries you, just remember: it’s all good! Should it ever rain again, more sturdy sand castles can be built with the wet sand.