by Steven Vannelli, CFA, Knowledge Leaders Capital
We think we could see a bullish back half of the year for equity markets. Our analysis follows in our Quarterly Strategy Report.
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1. Summary
- -In the first half of 2022, markets experienced the largest wealth destruction in three decades.
- -On June 17, 2022, the S&P 500 made a low that we think could be a durable low that propels stocks upward for the next 5-6 months.
- -While we haven’t seen a typical selling climax with the VIX soaring above 40, we think there has developed a collection of indicators suggesting stocks are washed out given the consistent selling pressure this year.
- -Retail traders, after the elimination of commissions, have become much more significant players in the stock market. While they spent most of 2021 buying calls consistently, they helped drive the equity market higher.
- -Now, retail traders have turned tail and for the better part of 2022 they have been putting on bearish positions (like buying puts or selling cash equities) while insiders have taken the other side of the trade, accumulating shares in their companies.
- -It appears that inflation may have peaked. Commodity prices of all kind have rolled over and monthly core PCE price index readings have slowed as well.
- -This helps explain why breakeven inflation rates have rolled over and the market is pricing in an almost 100% probability the Federal Reserve cuts rates in 2023.
- -We think we could see a bullish back half of the year for equity markets.
2. In the first half of 2022, markets experienced the largest wealth destruction in three decades. The current drawdown is almost double what we experienced in the Great Financial Crisis. (Chart: Finucane Financial, 6/29/22)
3. The S&P 500 experienced a 7-day waterfall decline, ending on June 17, 2022. Could this be the low for the year? We think the odds favor this hypothesis.
4. As of the June 17, 2022 low, there had been 5 out of the last 7 trading sessions where 90% of S&P 500 stocks traded lower. This has never happened before (since 1928, the first year recorded).
5. The next day, on Saturday June 18, 2022, Bitcoin broke to a closing low of $17,785.09. On Sunday it recovered to close at $20,607.54.
6. Traders are buying more puts than calls as measured by the option cost. (Chart: Sentiment Trader as of 6/28/22)
Construction per Sentiment Trader: This is the ratio of total put premiums paid each week relative to total call premiums, so it’s a direct reflection of how much options traders are paying for one relative to the other. That makes it an effective measure of real-money, real-time, leveraged sentiment. When it rises to an extreme, it is a highly reliable gauge of option-trader panic.
Current Reading: 1.01
Excessive Optimism: .5
Excessive Pessimism: 1.0
Tan-shaded areas represent bear markets (20% decline from 52-week high).
7. Small traders having been buying more and more puts all year. (Chart: Sentiment Trader, as of 6/28/22)
Construction per Sentiment Trader:
A small trader buys a call option to open a position for one reason – he thinks his stock is going higher. He buys a put option to open because he thinks his stock is going down. You may argue that he’s trying to hedge some underlying stock position, but it doesn’t matter. If he thinks his stock is going up, he’s not going to buy a put just for the thrill of it.
If we isolate the trades to just those of 10 contracts or less, and further restrict it to buys and opening transactions only, we can get a true picture of what retail traders (i.e. small brokerage firm customers) are doing.
This ratio looks at transactions that are buy-to-open only, and only for those trades that are under 10 contracts. Therefore, it is an excellent read on the emotions of the smallest of traders and should be interpreted in a contrary manner.
The indicator is constructed by computing the percentage of total small trader option volume that went to buying put options. It is a proxy for their speculative bets on a market decline. The higher the ratio, the more bearish these small traders are. When it becomes very high, that is a positive for stocks.
Current Reading: .27
Excessive Optimism: .17
Excessive Pessimism: .22
Tan-shaded areas represent bear markets (20% decline from 52-week high).
8. On June 17, 2022, the small trader put/call premium hit 1.27x. (Chart: Sentiment Trader, as of 6/28/22)
Construction per Sentiment Trader:
This is the ratio of total put premiums paid each week relative to total call premiums for small traders only (10 contracts or less), so it’s a direct reflection of how much options traders are paying for one relative to the other. That makes it an effective measure of real-money, real-time, leveraged sentiment. When it rises to an extreme, it is a highly reliable gauge of option-trader panic.
Current Reading: .9
Excessive Optimism: .4
Excessive Pessimism: .6
Tan-shaded areas represent bear markets (20% decline from 52-week high).
9. Small traders have racked up huge losses playing the options market this year, giving back the cumulative profits earned buying calls in 2020/21. (Chart: Sentiment Trader, as of 6/28/22)
10. Consumer sentiment toward stocks and bonds is a contrary indicator. The indicator oscillated from 0 to -80 in the last year. Forward returns historically are quite good 2-12 months out with a 100% hit rate. (Charts: Sentiment Trader, as of 6/28/22)
11. Retail buyers have stepped away from cash equity purchases over the last year, and now they are net sellers. (Chart: Goldman Sachs, as of 6/28/22)
12. Insiders are now taking the other side of retail traders selling. (Chart: Sentiment Trader, as of 6/28/22)
Construction per Sentiment Trader:
This shows a ratio of the total number of corporate insiders of Nasdaq 100 companies that have bought shares on the open market during the past six months versus those that have sold shares. Because insiders typically only buy if they have confidence that their company (and stock) will do well, insider buying is considered a stronger signal than insider selling. When buying picks up quickly and dramatically, it tends to be a very good sign for the stock market, so quick increases in this ratio tend to be a positive sign for stocks.
Current Reading: .1
Excessive Optimism: .03
Excessive Pessimism: .05
Tan-shaded areas represent bear markets (20% decline from 52-week high).
13. This helped the Nasdaq 100 Index (NDX) bounce off its 200-week moving average.
14. Options speculation has dropped to levels consistent with previous bear markets. (Chart: Sentiment Trader, as of 6/28/22)
Construction per Sentiment Trader:
The Options Speculation Index takes data from all the U.S. options exchanges and looks at opening transactions.
We total the number of transactions with a bullish bias (call buying and put selling) and also the number of those with a bearish bias (put buying and call selling).
The Index is a ratio of the total bullish transactions to the total bearish transactions.
Like most other put/call ratios, this is a contrary indicator, so when we see excessive speculative activity (i.e. the indicator moves outside of the upper red trading band), it means that traders are very confident of a rising market, and we usually see just the opposite.
When we see too much risk-aversion and the indicator moves below the lower green trading band, then we’re at a pessimistic extreme and we typically see a market rebound shortly thereafter.
Current Reading: .96
Excessive Optimism: 1.15
Excessive Pessimism: .90
Tan-shaded areas represent bear markets (20% decline from 52-week high).
15. Sentiment Trader’s model of optimism vs. pessimism is at levels associated with previous bear markets. (Chart: Sentiment Trader, as of 6/28/22)
Construction per Sentiment Trader:
This is the spread between the percentage of our indicators showing excessive optimism and those showing excessive pessimism. The higher the spread, the more likely stocks are seeing too much optimism and will struggle going forward. Another use is to check if the spread is positive or negative. If it’s positive (but not extreme…so between 0.0 and 0.2), then it means that overall sentiment is optimistic, and stocks will likely rise. If the spread is between 0.0 and -0.2, then sentiment is pessimistic but not extreme, suggesting stocks will have trouble rising.
Current Reading: -.25
Excessive Optimism: .2
Excessive Pessimism: -.2
Tan-shaded areas represent bear markets (20% decline from 52-week high).
16. The AAII Bull Ratio is testing all-time lows. (Chart: Sentiment Trader, as of 6/28/22)
Construction per Sentiment Trader:
The AAII (American Association of Individual Investors) is a non-profit organization headquartered in Chicago, and was founded in 1978. Their stated mission is: “assisting individuals in becoming effective managers of their own assets through programs of education, information, and research.” It is affiliated with NAIC, the organization that helped so many investment clubs get started in the late 1990’s.
Their niche market is individual investors, and not professional traders, pension funds, or anything else institutional. Their focus, and the focus of the great majority of their membership, is long-term fundamental analysis of sound companies using a very minimal amount of technical analysis for decision-making purposes.
The AAII sentiment survey is a weekly poll conducted by that organization which intends to gauge the overall sentiment of their membership. They ask their membership where they think the market will be in six months, and group the responses into three categories: bullish, bearish or neutral.
This indicator is a Bull Ratio, calculated by:
BULL RATIO = (BULLS / (BULLS + BEARS))
Like most contrarian indicators, when the survey shows too many investors as being bullish, it very often corresponds to market highs. Conversely, too many bears suggest that the market may soon find a low.
Current Reading: 23.5
Excessive Optimism: 65.0
Excessive Pessimism: 35.0
Tan-shaded areas represent bear markets (20% decline from 52-week high).
17. The CSFB Fear Barometer is back to COVID lows. (Chart: Sentiment Trader, as of 6/28/22)
Construction per Sentiment Trader:
The Credit Suisse Fear Barometer (CSFB) is an indicator specifically designed to measure investor sentiment, and the number represented by the index prices zero-premium collars that expire in three months.
The collar is implemented by the selling of a three-month, 10 percent out-of-the-money SPX call option and using the proceeds to buy a three-month out-of-the-money SPX put option. The premium on both sides will be equal, resulting in a term commonly known as a zero cost collar.
The CSFB level represents how far out-of-the-money that SPX put option is, or in insurance terms it represents the deductible one would have to pay before the put kicks in.
So, for example, if the CSFB is at 20, then that means an investor would have to go 20% out of the money to be able to buy a put with the proceeds from selling a call that’s only 10% out of the money. That means there is more demand for put protection – a sign of fear in the marketplace.
The index would rise when there is excess investor demand for portfolio insurance or lack of demand for call options.
It differs from the Chicago Board Options Exchange Volatility Index or VIX,. The VIX, calculated from S&P 500 option prices, measures the market’s expectation of future volatility over the next 30-day period and often moves inversely to the S&P benchmark.
The VIX is a fear gauge by interpretation, not by definition. It was designed to quantify the expectations for market volatility — a property that is associated with, but not always correlated to fear.
The Fear Barometer doesn’t work as most of us expect it to. It doesn’t necessarily rise as the market drops, or fall as the market rises. In fact, often it’s the exact opposite.
The reason is because traders in S&P 500 index options are mostly institutional, so the options activity is often a hedge against underlying portfolios. So when stocks rise, we often see more demand for put protection, not less.
When we see a sharp upward spike in the Fear Barometer, it means that traders are quickly bidding up put options, and the S&P 500 often sees a short-term decline soon afterward.
Conversely, when we see a sharp contraction in the Barometer, then we often see the S&P rebound shortly thereafter.
Current Reading: 16.08
Excessive Optimism: 33.0
Excessive Pessimism: 23.0
Tan-shaded areas represent bear markets (20% decline from 52-week high).
18. Advisors are as negative as they have been at good lows over the last decade. (Chart: Sentiment Trader, as of 6/28/22)
Construction per Sentiment Trader:
The Advisor & Investor Model (AIM) is a model consisting of sentiment readings from several popular (and some not-so-popular) advisor and investor surveys. The index is computed on a weekly basis.
This model takes advantage of the fact that when the typical investor and investment advisor should be most bullish, they are most bearish. And, when the markets are getting overbought and are about to turn, these Johnny-come-lately are most bullish.
When a preponderance of the survey respondents are more bullish than they’ve been in the recent past, then the model will move towards its upper (red) trading band. When it approaches this band (or exceeds it), then we should be concerned that too many investors are expecting higher prices, have likely already bought, and therefore support for further prices gains is minimal.
When the model has moved towards or outside of its lower (green) trading band, then we know that investors have soured on the market’s prospects to an extreme degree. This rarely lasts long, as the market has a strong tendency to rebound after such episodes. These signals are especially strong when the market tone is positive (e.g. the 40-week moving average of a broad index like the S&P 500 is rising).
Current Reading: .02
Excessive Optimism: .75
Excessive Pessimism: .25
Tan-shaded areas represent bear markets (20% decline from 52-week high).
19. Active Investment Managers are pessimistic as a group. (Chart: Sentiment Trader, as of 6/28/22)
Construction per Sentiment Trader:
From the website of the National Association of Active Investment Managers:
NAAIM member firms who are active money managers are asked each week to provide a number which represents their overall equity exposure at the market close on a specific day of the week, currently Wednesdays. Responses can vary widely as indicated below. Responses are tallied and averaged to provide the average long (or short) position or all NAAIM managers, as a group.
Range of Responses:
200% Leveraged Short
100% Fully Short
0% Cash or Hedged to Market Neutral
100% Fully Invested
200% Leveraged Long
Data collection issues that may affect the statistical significance of this data include:
Use of a single, composite number for each adviser may not accurately represent the market view of a manager who has short term and long term strategies that are providing conflicting signals or a manager who uses both contra-trend and trend following strategies for different portfolios.
Investment Styles very widely among managers participating in this survey. They may include managers that trade very frequently and can switch long and short positions daily. Other managers stay fully invested at all times and only change allocations among market segments or sectors. Still others trade around core positions and only a portion of their portfolios change, but that portion could potentially go from long to short very quickly.
Sample size: Although the number of participating managers, known as NAAIM Trend Setters, is steadily growing the sample size is not large and therefore may be less reflective of actual market conditions.
Current Reading: 19.9
Excessive Optimism: 80.0
Excessive Pessimism: 20.0
Tan-shaded areas represent bear markets (20% decline from 52-week high).
20. Investors are in panic mode after spending a year in euphoria territory. (Chart: Sentiment Trader, as of 6/28/22)
Construction per Sentiment Trader:
This model is based on the Citi Panic / Euphoria model that is published in Barron’s magazine. It does not reflect those published values, rather it is our interpretation of the model inputs and construction, and differs modestly from the published figures. The inputs are the same, however its performance as a contrary indicator is improved over the published values. It is composed of the following primary inputs: NYSE short interest, margin debt, Nasdaq vs NYSE volume, Investor’s Intelligence survey, AAII survey, retail money market funds, put/call ratios, commodities prices, and retail gasoline prices. The higher the model, the more investors are in a euphoric mood, with lower expected stock returns going forward. Low values, particularly below zero, suggest that investors have panicked, and higher forward returns are expected.
Current Reading: -.169
Excessive Optimism: 1.0
Excessive Pessimism: 0.0
Tan-shaded areas represent bear markets (20% decline from 52-week high).
21. On April 22, 2022, the Equity Hedging Index hit 80.8. (Chart: Sentiment Trader, as of 6/28/22)
Construction per Sentiment Trader:
There are many ways in which an investor or speculator can hedge against a stock market decline, among them:
Raise cash
Buy put options
Buy an inverse exchange-traded fund
Buy an inverse mutual fund
Sell short a futures contract
Buy credit default swaps
The Equity Hedging Index looks at each of those factors above and compares the current level to its historical average. The more each indicator shows hedging activity, the higher the Equity Hedging Index will be.
This is a contrary indicator, meaning that the higher the Equity Hedging Index is, the more likely stocks will rally going forward; the lower the Equity Hedging Index, the less likely stocks will rally.
The reasoning is the same as for most contrary indicators. When hedging activity is very high, it shows that investors are nervous about the market’s returns and have likely already sold (or, obviously, hedged). So further stock declines will not be as likely to prompt them to panic by dramatically lowering their ask prices and drive prices lower. This is evident when the Equity Hedging Index rises above 80, but in a roaring bull market the Index might only make it to 60 or 70.
At the other end of the spectrum, a very low (below 20) Equity Hedging Index shows that investors are supremely confident in a rising market, and feel little need to reduce their potential returns by hedging themselves against a decline that never seems to come. While that can pay off, it’s an aggressive stance, and markets tend to punish that kind of confidence. Therefore, an Index below 20 is a warning sign for stocks.
Current Reading: 64.4
Excessive Optimism: 20.0
Excessive Pessimism: 80.0
Tan-shaded areas represent bear markets (20% decline from 52-week high).
22. At a major low, like 3/23/20, there are a minimum of 5 ARMS Index readings over 2.0. More recently, there have been 6 days between 4/8/22-6/13/22. (Chart: Sentiment Trader, as of 6/28/22)
Construction per Sentiment Trader:
The TRIN (TRading INdex) was developed by technician Richard Arms, and has become a staple of almost all technicians’ cadre of indicators. Its is more properly referred to as the Arms Index.
It is calculated as follows:
(Advancing Issues / Declining Issues) / (Up Volume / Down Volume)
For example, say we have 1500 issues which closed a given day higher and there was a total of 1.2 billion shares traded in those issues. Also, there were 700 issues which closed lower on a total of 500 million shares. The Arms Index would be:
(1500 / 700) / (1,200,000,000 / 500,000,000) = 2.14 / 2.40 = .89
A reading of 1.0 typically shows that there is even pressure between buying and selling. As selling pressure increases, the Arms Index increases. As buying pressure takes over, the Arms Index drops. Therefore, one usually sees very high readings near market lows and extended bouts of low readings near market peaks.
There have been many interpretations and twists on the Arms Index over the years. We have found that using the 10-day average of daily readings provides an effective counter-trend indication of probable turning points.
The index is most effective when giving counter-trend signals – overbought in the context of a longer-term downtrend, or oversold within an uptrend. Like most contrary indicators, oversold readings during a declining market can continue to become more oversold as the trend persists.
Generally, however, readings which exceed one of the green or red bands on the chart can be considered extreme and indicate that the trend may be becoming exhausted.
23. NYSE breadth is at extremely pessimistic levels. (Chart: Sentiment Trader, as of 6/28/22)
Current Reading: 20.57
Excessive Optimism: 70.0
Excessive Pessimism: 30.0
Tan-shaded areas represent bear markets (20% decline from 52-week high).
24. The economic backdrop is one where inflationary pressures appear to be abating. Commodity prices—from energy to metals to agricultural products—appear to have peaked.
25. Oil, in particular, has been a nagging source of inflation. The US Treasury market seems to be pricing in lower oil prices—something in the $70-80/barrel range.
26. Inflationary pressures are already fading. After peaking at an annualized rate over 7% last summer, monthly Core PCE Price Index changes annualized have been trending down since then. The current annualized rate of the Core PCE Price Index is 4.13%.
27. This helps explain why breakeven inflation rates have been in retreat across all maturities. Longer run inflation expectations are well contained in this picture.
28. Peaking inflation is not going unnoticed by fed funds traders. As of this writing, the market is pricing in a 96% chance fed funds are cut in 2023.
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The information contained herein is provided for informational purposes only and should not be regarded as an offer to sell or a solicitation of an offer to buy the securities or products mentioned, nor should it be regarded as investment, tax or legal advice. Please consult an appropriate professional advisor for advice specific to your situation. Knowledge Leaders Capital may deviate from the opinions, investments, or strategy implementation as discussed in this presentation. The strategies discussed in the presentation may not be suitable for all investors. Knowledge Leaders Capital makes no representations that the contents are appropriate for use in all locations, or that the transactions, securities, products, instruments, or services discussed are available or appropriate for sale or use in all jurisdictions or countries, or by all investors or counterparties.
An investor cannot invest directly in an index.
Past performance or historical trends are not indicative of future results.
