The calendar year may have changed recently, but the underlying trend in global equity markets has not. The bulls are still in charge and the major indices have all continued to track higher (talk about year highs when it is only a handful of days old is simply ridiculous although it happens!).
In terms of Wall Street, as we and almost all value-based investors have noted, from a historical perspective it is hard to argue that US large cap equities are cheap, rather the contrary – they appear richly priced[1].
According to one school of thought, the continued gains in US equity prices when valuations are stretched is just a classic example of “irrational exuberance”. Indeed, as we noted in our final Market Insight of 2017[2], using market-price-based proxies of investor sentiment, it is easy to see why some have arrived at such a conclusion.
Does this mean the answer to the children’s classic travel question “Are we there yet?” – there being an end to the second longest Wall Street bull market on record – is now yes?
Our crowd-sourced sentiment data suggest not. In fact, there is strong evidence supporting an alternative, diametrically opposed, market scenario.
One of the recurring themes in our market commentaries over the past several quarters has been that when one examines the collective tone of millions of online financial comments posted every day – encompassing both traditional and social media – extreme bullishness has been (and remains) largely absent[3]. In fact, scanning across the major indices, we observe extremely high crowd-sourced sentiment in only two equity markets – India’s Nifty 50 and the Swiss SMI (see exhibit below).
Exhibit 1: Crowd-Sourced Sentiment – Major Equity Indices
Source: www.amareos.com
Hence, a top-down look at our crowd-sourced sentiment indicators directly contradicts the irrational exuberance bubble scenario and not just in the US, which is the primary focus of this Market Insight, but globally.
What our indicators appear to be picking up, something that may not be fully captured in surveys/market prices, is that there has been a high degree of skepticism about the ongoing rally in US equity prices.
After all, consider the slew of articles in the financial press over the past year warning about the overvalued equities and the possibility of a stock market crash. If it subsequently transpires that we are on the precipice of a major decline in US equities (probably global given contagion risks), then this will be one of the most predicted “bubble bursts” we have ever encountered.
Markets tend not to operate that way. Our perception of how markets operate is more masochistic. We see prices tending to move in a manner that…
“inflicts the most pain, to the most number of people, in the shortest space of time”.
A touch cynical perhaps, but based on our many years on the buy-side, true nonetheless.
At present, we judge the most pain to be on a move higher in US stocks, not lower. To explain why we need to take a look at how our US equity sentiment indicators evolved over the past year.
As mentioned, crowd sentiment towards US equities is marginally above the long-run average suggesting only mild optimism. This is the case – and has been for much of the past 12 months – because of an absence of positivity in traditional financial media. Indeed, we commented on unusual divergence between the tone of the two media types, with social (which we consider to be more reflective of a retail investor mindset) being considerably more positive than traditional media (which we consider to be more reflective of a professional investor mindset) in an earlier Market Insight[4].
While we cannot know this with absolute certainty – we convert millions of online articles posted every day from text into data for a reason (it being impossible to read everything that is published) – our strong belief is that this skepticism amongst professional investors comes from a sense that the bull market has been a “central-bank-induced-fake” whose foundations are in the process of being undermined by the removal of monetary stimulus.
Exhibit 2: Crowd-Sourced Sentiment By Media Type – S&P500
Source: www.amareos.com
The economic logic that underpins such skepticism is sound given that monetary policy can only generate intertemporal redistributions of aggregate demand ie. bring future demand forward, it can’t create it out of thin air. However, asset markets do not always act in accordance with economic logic and for those investors who have been underweight equities based on such logic the continued ascent in equity prices has been painful.
The financial pain is rather obvious. Underperformance is never good for an active manager but especially so at the present time given the increasing popularity of lower-cost passive investments. Less obviously, but potentially just as powerful, is the emotion pain.
FOMO, or the Fear Of Missing Out, (the acronym only came to prominence in the past few years as a result of its social media usage but its long-hand version has been known for much longer) triggers a response in the amygdala area of the brain as social exclusion is perceived as a threat. Like many other traits evolution endowed us with to help us pass on our genes successfully to the next generation, it has unexpected side-effects in terms of how we perform as investors.
Given the relative lack of enthusiasm for US equities amongst professional investors compared with their retail counterparts, a perspective challenged by the ongoing rise in equity prices (so much for “smart” versus “dumb” money labels), the FOMO effect is likely to be most potent with the former.
Indeed, glancing at the right hand side of the above exhibit, shows the two series have converged over the past several weeks, with social media becoming less positive, whereas traditional media has become more constructive in tone. This recoupling is important.
Unlike the irrational exuberance view, which implicitly implies that the next major move in equity prices is downward, if the FOMO effect is at play the implications are markedly different. Not only would it suggest that the second longest bull market on record has longevity, but as investors buy US stocks to avoid “missing out” it could trigger a “melt-up” in equities – a scenario recently outlined by GMO’s Jeremy Grantham[5].
Same (overvalued) starting point – two very different market outcomes.
The recent uptick in mainstream media sentiment, is not the only evidence supporting the FOMO-driven “melt-up” scenario. The algorithms underlying our sentiment indicators are calibrated so as to be able to identify individual emotions, such as Joy, Anger, Disgust etc, contained in online financial media posts.
Of the eight individual emotions we identify, our previous research indicates that Fear is the most useful as it is strongly correlated with equity market corrections (and periods of rising volatility[6]). Even though, Fear and FOMO share a common word – fear, rather obviously! – the two have very different connotations and linguistic fingerprints. Indeed, Fear can be considered the exact opposite of FOMO. The former reflects worries that the stock market will decline whereas the latter stems from investors’ concerns about missing a continued price rally.
Exhibit 3: Crowd-Sourced Fear Sentiment – US equities
Source: www.amareos.com
Hence, to be consistent with the FOMO hypothesis, one should expect crowd-sourced Fear sentiments towards US equities to be on the low side, and indeed this is what we observe – see exhibit above. In fact, over the past week or so, Fear sentiment towards US equities has fallen to record lows – a trend that is by no means exclusive to the US. Scanning across the major equity indices, one can readily observe that Fear sentiment is either low or extremely low with the exception of the Brazilian BOVESPA – see exhibit below.
Exhibit 4: Crowd-Sourced Equity Fear Sentiment – Global Heatmap
Source: www.amareos.com
The final, and in our judgement the most compelling, piece of evidence for the FOMO effect comes from the rise in our crowd-sourced Stress indicator for US equities. As shown in the exhibit below, Stress has risen sharply over the past several weeks.
Exhibit 5: Crowd-Sourced Stress Indicator – US & S&P500
Source: www.amareos.com
Given the jump in the US Equity Stress indicator one would expect there to be some readily identifiable catalyst. Typically, a rise in equity Stress would correlate with developments such as a slump in asset prices (as occurred in early 2016), increased worries about US economic prospects and/or other non-economic events, such as geopolitical tensions that would also show-up in the country level indicator – see exhibit above.
But, US economic prospects remain constructive and Stress at the country-level, although it has been elevated previously, has begun to fall[7]. Ruling out these two possibilities, and obviously in the absence of a market correction, the natural candidates for rising Stress in US equities are missing. However, one would expect to see Stress pick-up as equity markets continue to march higher if the FOMO effect was at play as this would be consistent with the emotional pain described previously.
Assuming this to be the case, then not only should US (and global) equity markets continue to defy “valuation gravity” but price momentum could very easily become even more positively skewed consistent with an unfolding of the “Melt-up” scenario. This is because the intensity of the FOMO effect becomes greater the more equity markets rise, which in turn encourages more former sceptics to convert (a temporary positive feedback loop is created). In much the same way as commuters who scramble to make the last train home feel great when they finally jump onboard, the conversion would boost sentiment and contribute to lowering stress levels.
However, and not without some irony, a FOMO-induced “melt-up”, marked by rising crowd sentiment and declining stress would, when combined with stretched valuations, bear the hallmarks of a classic “irrational exuberance” bubble top.
That would be the point at which to worry, but we are not there yet!
FOOTNOTES:
[1] See: https://www.amareos.com/financialresearch/the-market-sentimentalist-are-the-stars-aligned/
[2] See: https://www.amareos.com/financialresearch/the-market-sentimentalist-anatomy-of-a-bubble/
[3] In addition, to the Market Insights referenced in the above footnotes – see: https://www.amareos.com/financialresearch/the-market-sentimentalist-were-going-on-a-bear-hunt/
[4] See: https://www.amareos.com/financialresearch/market-sentimentalist-riding-wave/
[5] See: https://www.gmo.com/docs/default-source/research-and-commentary/strategies/asset-allocation/viewpoints—bracing-yourself-for-a-possible-near-term-melt-up.pdf?sfvrsn=4
[6] We consider the labelling of the VIX – the implied volatility index relating to the S&P500 – as the market’s “Fear” gauge to be misleading – see: https://www.amareos.com/financialresearch/the-fear-factor/
[7] At the country level, the US presently is the top of the leader board when it comes to Anger and Disgust – something we strongly suspect is related to feelings about President Trump more than anything else.
