By Roman Chuyan, CFA
Elevated short-term risk on investor exuberance
- We have captured most of the market upside in November.
- While our 6-month Equity Model continues to indicate Positive Fundamentals, our Short-Term Risk model now gives a Sell signal because of exuberant investor sentiment.
The stock market rebounded strongly as investors turned optimistic after the election and positive vaccine news. November was the best month since April – the S&P 500 gained 11% in the month, taking its year-to-date gain to 14%. We had increased our equity exposure to a maximum on November 2nd on our models’ positive signals, which allowed us to capture most of the upside – instant gratification, which is very unusual in investing.
US and Foreign Stocks, Year-To-Date
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Has the market rebounded too far, too fast? Sustainable rallies typically begin when the market is cheap, and continue on solid economic performance. Neither of these is in place now. The S&P 500 is overvalued by 14% according to our 6-month Equity Model, and economic factors provide only a low positive contribution. Instead, our model detects that the November rebound was based on investors redeploying cash after a short-term gain, or pure momentum.
Momentum rallies tend to end when investors fully deploy the cash earmarked as part of their risk assets, and there’s no buying power left. We can detect this with investor-sentiment measures. Our Short-Term Risk model includes a contrarian Investor Sentiment tool that detects the patterns of exuberant sentiment preceding market corrections.
Our Risk model gave a Sell signal in the latter part of November based on its Investor Sentiment component. This pattern is characterized by quick reversal from bearish to exuberant sentiment when stocks rebound too far, too fast. Sentiment measures improved quickly and reached exuberant levels on a quick rise in the S&P 500 index in November. For example, the AAII Bears-to-Bulls ratio dropped to 54% on a moving-average basis (that is, bullish investors outnumber bearish by almost 2-to-1):
Another example is the Put-Call Ratio – the ratio of Put (bearish) to Call (bullish) options purchased by traders, mostly investment banks and hedge funds. A low Put-Call Ratio indicates bullish positioning, which is what we see now:
Let me finally note that only a couple of negative indicators wouldn’t necessarily mean danger ahead. However, our Sentiment tool includes a combination of seven indicators combining into certain patters that historically precede market corrections.
Now, a quick look at the economy. While economic rebound in Q3 was phenomenally strong, some indicators have weakened recently. Consumer Sentiment, which leads consumer spending, unexpectedly dropped in November to 76.9, and the Consumer Expectations sub-index weakened to 70.5. The earlier rebound in consumer sentiment now looks very similar to previous mid-recession bounces.
While stocks reached all-time highs, there are plenty of potential triggers for a correction. The vaccine is becoming available in record time as part of the administration’s Operation Warp Speed, so investors are choosing to ignore the pandemic for now. However, daily deaths rising above 2,000 last week and reaching a new record of 3,000 this week might lead to more widespread lockdowns similar to those now in place in Europe. In a Nov-29th interview, Dr. Fauci warned that he expects a “surge superimposed on the surge we are already in” after Thanksgiving travel. This appears to be unfolding. A large part of California is already under stay-at-home order. Also, the process of vaccinating the entire US population might take time and face unforeseen obstacles. As always, our investment process will be guided by our models.
About Model Capital Management LLC
Model Capital Management LLC (“MCM”) is an independent SEC-registered investment advisor, and is based in Wellesley, Massachusetts. Utilizing its fundamental, forward-looking approach to asset allocation, MCM provides asset management services that help other advisors implement its dynamic investment strategies designed to reduce significant downside risk. MCM is available to advisors on AssetMark, Envestnet, SMArtX, and other SMA/UMA platforms, but is not affiliated with those firms.
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