Brad M. Weafer, CFA, Chief Investment Officer
Sentiment Data Suggest Investors are Pessimistic, a Good Sign for U.S. Equity Investors
“…be fearful when others are greedy and greedy only others are fearful.” – Warren Buffet
Famous investor Warren Buffet’s quotation above is referenced so often that it has become a cliche. His message, however, is as relevant and important as ever. Investing is characterized by emotional overreaction. When things are going well, many extrapolate current good times into the future, seeing no risk things will ever turn negative. When times are bad, many assume things will never get better. Often this leads emotional investors to invest through the rear view mirror, buying when expectations are highest and selling when the best opportunities lay ahead. When the investment herd moves too far in one direction, smart long-term investors must take notice and position their investments accordingly.
Equity markets have again rewarded 2017 with double digit returns. With the last bear market a distant memory, we are on guard for worrying signs of “irrational exuberance”. Instead we find more signals of cynicism on recent returns and pessimism on the outlook for the future. For months, almost every financial news talking head and market pundit has been waiting for an impending “correction” that has not come. More importantly, the data suggests investors are positioning cautiously. Contrarians take note, this lack of excessive optimism is a positive sign for equity markets and suggests the end of this bull market is not imminent.
Let’s look at a few examples to illustrate the point.
We would expect to see net purchases of U.S. equities, the best performing asset class in this most recent cycle. If investors were chasing the recent winners, we would also expect to see inflows into equities coming from safer assets like fixed income. The data suggests the exact opposite. According to the Investor Company Institute, investors have been net sellers of domestic mutual funds and ETFs for six straight months. During that time, fixed income funds have seen ten times the amount of inflows. The recent increase in U.S. stock fund sales highlights cynicism and concern over the future. This is a continuation of a trend that has been going on for several years. Since the start of 2015, over $180 billion has been removed from equity funds, while bond funds have seen a near $500 billion in increase (see figure below).
How about positioning within those mutual funds? When mutual fund managers are overly confident, they are more inclined to have the funds manage fully invested. When they are more pessimistic, they are slower to invest and let cash build up. Bank of America/Merrill Lynch track the average cash levels mutual fund managers are holding monthly. Historically, when cash levels exceed 4.5% of the portfolio, it sends a contrarian buying signal. Today managers are holding on average 4.8% in cash, highlighting a level of conservatism from managers. Again, this is not what you expect to see near all-time highs in the S&P 500, providing further bullish sentiment evidence.
The easiest and most visual way to gauge investor attitudes is through the lens of the financial press. Newspaper headlines and magazine covers tend to embellish popular sentiment. It caught our eye several weeks ago when the cover of Barron’s magazine struck a decidedly downbeat tone asking, “How this Bull Market Will End”. No signs of excessive optimism from Barron’s.
Every cycle is different, but if the end of this equity bull market is near, the normal signs of over-enthusiasm certainly do not appear present to us. Economic and corporate fundamentals continue to paint a positive picture, and sentiment provides additional comfort for our positive review on U.S. equities.