2023-04-13 16:17:18 ET
Summary
- Since the S&P 500 hit bottom over 25 weeks ago, the index has gained 15%.
- Yet, fifteen sentiment indicators still show high levels of bearish sentiment and caution. This seems to support the idea the market is rising against the classic “wall of worry”.
- It's illogical to be bearish on stocks because of economic conditions since stocks are one of the 10 leading indicators for the economy. It’s putting the cart before the horse.
- With that said I, like many, can't shake a strong feeling of “foreboding” about the stock market.
- How is this tense standoff going to resolve? We outline the most probable outcome.
We use two sentiment indicators - the master sentiment indicator and the short term master sentiment indicator. They're both composite indicators made from fifteen other indicators. They show what investors feel about the market by analyzing what they're thinking and doing about it. Although records go back to 2007, to show the situation in greater detail both indicators are graphed from 2018 to present.
They both reveal that, since the market lows of last July and October, investor sentiment remains very cautious.
The Master Sentiment Indicator (Michael McDonald) The Short Term - Master Sentiment Indicator (Michael McDonald)
The top indicator (Master Sentiment Indicator) measures what investors think about the market long term, while the other measures short term expectations. As the charts clearly show, both indicators remain near the Green Zone, which represents extreme levels of bearish sentiment.
This is unusual six months after major price low. For example, following the extreme bearish readings in April of 2020, it took about two months, or less, for the indicators to go across the zero line toward the Red Zone. The current reluctance to give up on a bearish viewpoint five months after the price lows is a sign that prices are slowly rising up against the famous "wall of worry" and doubt.
The master sentiment indicators
The table below lists the nine indicators that make up the master sentiment indicator. It also shows where each sits on the sentiment scale. This earlier article lists and explains these indicators and the method of construction of MSI and ST-MSI in greater detail.
The Nine Components that make up the MSI (Michael McDonald)
Both the buying levels in the ProShare S&P short fund ( SH ) as well as the survey of American Association of Individual Investors remain close to the green zone of extreme bearishness. Likewise, the degree of "put" buying as measured by the "puts to calls" ratio of both equity and total options are not far away.
Only one indicator - the Hulbert survey of NASDAQ newsletter writers - has moved one notch past the neutral zero line. These metrics of sentiment show the classic "wall of worry" with investors reluctant to be bullish, even after a five month rally.
The indicators listed in the table below are the ones that go into making the Short Term Master Sentiment Indicator.
The seven components that make up the ST-MSI (Michael McDonald)
These indicators are calculated on a daily basis. The difference between some of these indicators and their long term counterparts in the MSI is the different time periods over which they're measured.
These seven sentiment metrics also indicate a reluctance by most investors to take a bullish stance on this stock market. It too confirms the idea that stock prices are slowly rising against a "wall of worry" and doubt. Most investors state that they're worried about the widely anticipated recession.
The economy or the market
Making a bullish statement today about the stock market is more often than not answered with this question, "But how about the recession?" This blunt question stops almost everyone. But the question fails to consider this simple fact: the stock market is officially considered one of the best leading economic indicators for the economy. In fact, it's one of the ten components of the LEI.
So, how can one use the state of the economy to predict an indicator that predicts the future state of the economy? You can't and be logical about it, but they still try. A sudden drop in interest rates correlates much better with predicting higher stock prices than any data about the state of the economy. And if anyone's noticed recently, that's exactly what's been happening. I don't doubt we'll have a recession but I think a lot will happen in the market until we do.
The resolution
With that said I too, like many, can't shake a strong feeling of "foreboding" about the current stock market. But it's not a foreboding about a recession. It's a foreboding about something unexpected happening; some major global event that cascades down and sets off another selling wave. That risk, however, is always there. To mentally overcome it one just grits their teeth and goes forward assuming that if something does happen prices will go lower.
Most probable (but least satisfying) outcome
I first discussed this scenario here . It's a price forecast for the market based on a well know Elliott Wave price pattern called a "flat." While I don't use the Elliot Wave theory often, there are times when it is very useful, and in my opinion, this is one of those moments. It helps establish guidelines and limits on what can and can't happen.
The Forecast of a large Elliot Wave Flat (Michael McDonald)
In my view, the most probable outcome that resolves the current situation is a large Elliot Wave flat. People think in terms of bull and bear markets, they don't usually forecast large, trading range markets. But that's what a large ABC "flat" is.
With this scenario, prices should continue to rise against the "wall of worry" back to the previous top on the S&P 500 of $4,800. This is point "B." By that time market sentiment should swing back to the bullish side, setting the stage for another price decline (Point C), probably triggered by an unexpected hit to the economy.
What is this ABC flat pattern really? It's a bear market composed of three waves - two down and one up. In this case the up wave, the bear market rally, is so strong it takes prices back to the beginning of the bear market. Then it reverses and comes down again in a second wave, this time accompanied by a severe economic downturn. In total it would last about two and a half years. It's classic Elliott Wave, right out of his books.
Take away
Investors think in terms of bull or bear market, that prices are either rising or falling. They also think the economy is either expanding or in recession and that bull markets go with expansion and bear markets with recession. But the theory of contrary opinion tells us this picture is far too simple. If too many people expect one thing you don't get it, and vice versa. Fitting it all together when forecasting the market is the challenge.
The continuing high level of bearish sentiment five months after the October price low is the sign of the famous 'wall of worry' that accompanies a continuing advancing market. It portends higher prices. Yet the expectation of a recession and lower prices again stands out in front of us. A market forecast that fits these two ideas together is that we are in a large trading range market, a market that's neither bullish nor bearish.
For further details see:
Is This The Classic 'Wall Of Worry?'