By ION SIORAS
As investors, we spend much of our time considering equity fundamentals. These considerations cover items such as relative equity market valuations, the potential future paths of earnings and gaining a deep understanding of individual business models and industry dynamics. We strongly believe that such matters are the determinants of positive or negative returns for assets over the medium to long term.
During volatile periods, such as the one we are experiencing, other indicators can be brought to bear. Sentiment tends to overshoot. ETF funds are required to programme purchases and sales of huge amounts of securities. So called systematic participants (model or quant driven funds and traders) move in and out in high volumes. Not for nothing they are called ‘trend followers’. When the trend breaks, they are obliged to follow.
All this can be understood as the psychology of crowds.
Panics and euphoria’s can drive asset prices from “cheap” to “bargain” or “expensive” to “eye watering” on valuation metrics.
Through experience and continued participation in markets through multiple major events, we have found merit in non-valuation based indicators that try to illustrate how positioning, sentiment and participants may be set in the market. We have been operating such a model for several years.
No one indicator can adequately and reliably describes these extremes. No indicator can capture the sentiment of all participants or the entire spectrum of positioning. What we have found is that a blend of indicators – some sampling sentiment and others tracking the bias of positioning in markets.
The method we use incorporates ten such indicators into a simple proprietary model. When compared against the World Equity market we believe it reliably indicates peaks and troughs in aggregate sentiment and positioning.
The implication is that investors should extend risk at troughs (to secure better than average returns in the years that follow) and lighten up on risks at the top of the range.
It should also be noted that, outside the extreme levels (when the dark blue line is either bisecting the red guidelines indicating maximum bullishness and maximum bearishness), the model itself is giving no signal. This means that, to be used in a disciplined and reliable way, the model spends most of its life giving no signal at all.
The dark line in the below chart tracks the indicator’s oscillation over time. The red crosses describe the ‘spot reading’ based on the unsmoothed data series. The dark line is the true signal – but only at extremes – and the most recent red cross shows the likely direction of the smoothed line.
At the time of writing, we observe that equity markets are moving rapidly from euphoria to panic (dark line falling). The imposition of global tariffs, if maintained at current levels, would create a heart attack in world trade and growth in multiple major economies. The question behind this for investors is how much negative news has been priced in by the market very quickly. Any de-escalation would be greeted with relief as, from a US perspective, this is somewhat of a self-imposed crisis.
Below we examine some of the sub-indicators that enter the Cerno Market Positioning Indicator (CMPI) that we think are relevant to elucidate our points.
Volatility based measures
Two volatility related indicators that are commonly referenced by market participants are the VIX index (which measures volatility or the propensity of prices to be moving rapidly in either direction) and the put/call ratio (which measures the balance of option trades by volume in the US equity market). These are good examples of “positioning” based indicators, that capture investor buying and selling activity (in this case with respect to equity options). Both of these indicators are incorporated in the CMPI.
As summarised above, the put/call ratio is a simple measure that calculates the total volume of equity call contracts (betting on an index price rise) versus equity put contracts (betting on an index price fall) that are traded in a daily session on the Chicago Board of Exchange. A high put/call ratio indicates high demand for downside protection relative to upside capture. Extremes in demand for downside protection paradoxically often indicate a “low” in equity markets, as selling pressure is exhausted.
The VIX index is best described as a simple number underpinned by a complex calculation. Without delving into the statistical arcana, we can say that the VIX represents an estimate of the implied volatility for S&P 500 options with an average expiry of 30 days.
What this means in even simpler terms is that the VIX can be interpreted as a proxy for the expectation of future volatility, and thus demand for options to protect against that volatility. Crescendos in option demand (or expectations for short term volatility) usually cluster at the extremes of a selloff.
Sentiment measures
Sentiment measures have historically taken the form of investor surveys or polls. In recent years more automated methods such as scraping internet content to get a sense of investor emotions has been utilised, but such data sets remain proprietary and closely guarded.
Some of the more famous or widely read sentiment surveys include the Bank of America FMS (Fund Managers Survey) which polls fund managers that have an institutional relationship with the bank. More cynical market participants will talk about the “Barrons indicator” or the “Economist cover indicator” (essentially that major financial publications mark peaks and troughs in investor sentiment).
The two we have found most useful are the Investor Intelligence Advisors Sentiment Index and the AAII (American Association of Individual Investors) Bulls – Bears reading.
We will focus on the Investor Intelligence index.
The II Advisors Sentiment index is derived from a weekly sampling of stock market reports written by professional market advisors. The II team parse the commentary of each report and allocate it to a “bulls” or “bears” category. By subtracting the “bears” from the “bulls” a numerical figure for sentiment can be calculated e.g 40% bulls minus 30% bears would give a bull – bear spread of 10%.
Extreme readings of bullishness versus bearishness may persist for long periods (as markets typically trend upwards in a slow and steady fashion). Where we find the indicator has particular signalling power however is at points of extreme negative sentiment. There is an inherent bullishness of the professional investment advisor sector, given the natural alignment of incentives between their business models and healthy asset markets. To observe convicted and clearly articulated bearishness from a majority (bears exceeding the bulls on the indicator) is both rare and often coincident with a “capitulation” in selling activity. Indeed this relation can be observed when plotting the US equity market (the S&P 500 in this case) versus the indicator.
This relationship also holds for longer periods and we have historical data for this sentiment survey stretching back to the 1970s. Although the companies, sector composition and valuations of markets may change drastically over long enough periods, what such history tell us is that the one thing which remains constant is investor psychology.
We think it is particularly important to consult such indicators at the current juncture for two reasons. The stretch of volatility we have just experienced in US equity markets over the past 4 day period (with the daily trading range exceeding 5% each day) is commensurate only with October 1987, October 2008 and March 2020.
All were periods of tremendous stress and two out of the three marked a low that behoved sensible investors to hold their nerve and not liquidate their holdings.
Even more pertinently, when a confluence of such indicators triggers it can often presage a good opportunity for investors to deploy capital held in reserve. Although no method can describe the exact low point in markets, such non-valuation based triggers can point towards points where pricing has created a more attractive risk/reward opportunity.
Research conducted by CLSA using their own proprietary collection of indicators (based on the VIX Index discussed earlier in the piece and some volume based metrics) bear this out. When “capitulation” is triggered on their measures the S&P 500 is on average 2% higher over 30 days and ~6% higher over 90 days. Both of these readings have an 80% hit rate over a sample size of 26 occurrences.
Even more encouragingly, if such a confluence of indicators triggers at a more durable “bottom” the forward returns are even more attractive. Work previously presented during the 2022 bear market showed that the average 12 month return from a bear market low is 47%. The importance of hold on through that low or investing near such a point cannot be ignored.
At the time of writing, escalation continues unabated with China imposing an additional 84% tariff versus America’s 104%. Coherent arguments can be made about the secondary and tertiary effects of a full-blown trade war that the market has only begun to price.
What our indicators show however is that we have been here before, in different forms and different guises, and it may not be as bad as it at first seems. It is a market truism that the best time to invest is the time where investors are least disposed to invest.
Ion Sioras with additional commentary by James Spence
Appendix
Disclaimer
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