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February 15, 2018

The Market Sentimentalist – No Pain, No Gain

by Amareos.

The recent pullback in stocks has felt brutal.

As the chart below confirms, an 8% drop from the January 26th peak has only been exceeded a handful of times during the past decade. What has, without question, compounded this sense of brutality is that is has followed an exceptionally benign market environment that investors have become accustomed to over the past year or so – the maximum drawdown since Trump’s election victory was just a shade over 1% – highly asymmetric price action.

Exhibit 1: S&P500 Drawdowns – Cumulative And Monthly


Concomitant with the correction, equity implied volatility has spiked– with the closely watched VIX indicator having surged to around 40 from 11 at the recent stock market peak. Such a move is entirely consistent with the price action see to-date. As the exhibit below illustrates, the current level of the VIX is what one would expect to see during a high single digit percentage point correction.

Exhibit 2: S&P500 Drawdowns And VIX Implied Volatility

Source: and

Even though the move may have felt brutal, as things currently stand, the downward correction is far from unchartered territory for a bull market. As alluded to above, in the nine-year period since the S&P bottomed and the bull market began there have been four clearly identifiable corrections and implied volatility spikes of roughly the same magnitude. For those that believe that the bullish equity market trend remains intact, then the recent correction should represent a good buying opportunity.

If only it were so simple.

Unfortunately, it isn’t.

Just as “All journeys begin with a single step”, so it is with bear markets. They all begin as a correction.

How is one able to distinguish between a correction in a bull market and the start of a bear market?

One way is to consider the underlying psychological state of the crowd because when markets are moving quickly – as they are at present – emotions takeover and dominate the decision-making process as the brain reverts to the instinctive System 1 thinking[1]. This type of thinking is typified by the “fight or flight” response to fear – a gift from evolution.

Even though it is labelled the equity market “fear index”, as we have suggested on numerous occasions in the past[2], the VIX is not much help for investors because it is a contemporaneous indicator of the price action in the underlying market. (Note: some market commentators have blamed last the slump in US equities on exchange traded volatility products[3]. We are not broaching the issue of causality between implied volatility and the cash equity market here).

An alternative method is to analyze the emotional content of millions of online comments across traditional and social media posted every day. As we noted in a recent Market Insight[4], the prevailing mood of the crowd a month ago was one FOMO (Fear Of Missing Out), the antithesis of fear – indeed we showed our Fear sentiment indicator stood at record lows. What is interesting to note is that even with the latest price move and the surge in implied volatility, our crowd-sourced US equity Fear indicator (dark grey line) remains close to historical lows – see exhibit below.

Exhibit 3: Crowd-Sourced Fear Sentiment By Media Type – S&P500


For the most part, this absence of fear is largely reflective of the tone of social media (red line), which we take to be more representative of a retail investor mindset. By contrast, fear sentiment in mainstream media (orange line), which we take to be more representative of a professional investor mindset, remains significantly higher as it has done ever since Trump was elected President (divergence that was not evident during the Obama years).

What such low crowd fear readings suggest is that even though the VIX has jumped to levels where it has proved profitable over the past several years to re-enter the market a “buy-the-dip” mentality may not be being a winning strategy this time around. Indeed, because the crowd has not been scared by the extreme price action (read price falls) down rather than up is where the market’s vulnerability is higher, which suggests the downward correction probably still has further to run.

Does this mean that, conversely, we are staring down the barrel of a major trend reversal and the start of bear market in stocks? The answer to that is probably no as well.

Admittedly we only have one example of a bear market for which our crowd-sourced sentiments are available so one needs to be careful interpreting the data. However, when we look at the months leading up to the start of the Great Recession, what is clear is that while the US equity market peaked in early October 2007, the bulk of the P&L damage occurred in the period subsequent to January 2008. As can be seen in exhibit below, this was after a period of high and sustained crowd fear (average readings above 40 with occasional spikes above 60).

Exhibit 4: Crowd-Sourced Fear Sentiment vs. Cumulative Drawdowns – S&P500


The psychological make-up of bear markets is fundamentally different from common-or-garden corrections – they occur against a backdrop of deep-seated fear. At present, we are a long-way from such an occurrence.

Another facet of our crowd sentiment that makes us believe that we are not at the start of a major bear market in stocks is one our regular readers will be familiar with. Although the timing of this downward correction caught many investors off-guard, there has been plenty of skepticism about the bull market. (Markets are great teachers of humility. Whenever one begins to think they have a handle on them they move in unexpected ways – a lesson we (painfully) learned during our years on the buy-side.) When one looks at the totality of crowd sentiment, not just the snippets – our mental capabilities being limited as they are – that informs our anecdotal experience, the evidence of over-exuberance is missing. Sentiment towards US large cap equities is far from extreme – see exhibit below.

Exhibit 5: Crowd-sourced Sentiment – S&P500


This, of course, does not mean that a downward correction cannot occur, it patently can and in fact, as noted above, we see potential for this current slide in prices to run a while longer. However, it does point to an absence of emotional fuel required for this to be the “big one”. Major market tops – like the dotcom bubble or the US housing bubble – are always marked by excessive optimism and a sense that prices can never fall. Such perceptions are not evident in how the crowd currently views equities.

There is a final aspect of our crowd sentiments that has a bearing on equities, one we outlined in some detail in the previous Market Insight[5] and consider important, but has not received much attention.

The main worry weighing on equity markets is the impact of rising (primarily US) interest rates. Given the perceived positive economic backdrop, and the potential pick-up in inflation, US Treasury yields have risen – a change (so the argue goes) that makes investors less willing to pay-up for stocks i.e. valuations need to be lowered.

Looking at the evolution of US economic growth and future inflation sentiment there is clear evidence of the crowd embracing this reflationary mindset – see exhibit below. Economic growth sentiment (dark grey line) is near its highest level since Trump’s election while future inflation sentiment (orange line) has also risen sharply (albeit not yet matching the peak of the immediate post-election Trumpflation surge).

Exhibit 6: Crowd-sourced Sentiment – US Growth And Future Inflation


Concentrating on the latter aspect, the rebound in US future inflation sentiment has coincided with a surge in sentiment towards crude oil. This is far from unusual. In fact, over the past decade every time US future inflation expectations have risen markedly it has been in tandem with a rise in crude oil sentiment.

Exhibit 7: Crowd-sourced Sentiment – US Future Inflation Vs. Crude Oil


However, rather than corroborating the bearish scenario by validating the crowd’s rising inflation expectations, such a strong positive sentiment skew in crude oil actually suggests the opposite[6]. Hence, our conclusion that the crude oil price was toppy. If correct, and since we published our last piece the crude oil price has fallen just over 3%, then this should will likely take some of the steam out of the reflationary mind-set of the crowd.

In addition to the direct effects on headline inflation, a falling crude oil price occurring against a backdrop of a falling equity markets – consistent with the positive correlation between crude oil and equity prices seen over the past decade – has the appearance of a negative demand shock. This is something central bankers will take note of and, if these price trends persistent (our expectation), would very likely prompt them to scale back, possibly even reverse, their policy normalization plans. To do otherwise would be a very brave step – one that central bankers have generally shied away from in the post Great Recession period. (The dip in bond yields in the past couple of sessions contains more than a whiff of such thinking).

Such a reversal would remove one of the primary reasons for investors having a bearish view on bonds and – hence by extension – stocks. Combined with the strong likelihood that Fear sentiment readings would be significantly higher at this point, this would provide fertile ground for the bulls.

That said, central bankers are not renowned for handbrake policy U-turns, especially not one’s “under new ownership”, so expect markets to remain unpleasant for a time. But, as the old saying goes, “no pain, no gain”[7].

Amareos crowd-sourced sentiment indicators are based on MarketPsych Indices


[1] As opposed to the slower, logical, System 2 thinking – a demarcation made famous by the behavioural psychologist Daniel Kahneman in his book “Thinking, Fast And Slow” – see:

[2] See:

[3] See:

[4] See:

[5] See:

[6] This relates to our concept of crowd fail – see:

[7] For the avoidance of doubt, we are not “Kool-Aid” drinking equity bulls – quite the reverse. We have grave concerns about the underlying health of the global economy, particularly given the very high levels of indebtedness. At some point, we fully expect to write the phrase “the big correction is upon us”, we just don’t believe we are at that point at this moment in time.

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