The Market Couldn’t Look Better … Which Can Mean Only One Thing

by Daniel Putnam | January 14, 2013 11:00 am

Talk about climbing the “wall of worry.”

Even though the past six months have brought an abundance of negative headlines, the S&P 500 has tacked on more than 10% since its July low. During this time, anyone who reacted to the news flow by selling stocks or actively betting against the market has paid dearly.

But now, we might finally be entering a period in which investors will be rewarded for taking a more cautious stance — and this time, the bear case doesn’t rest on macroeconomic events, but rather some key sentiment indicators for the market. Three factors stand out as potential warning signs:

#1: Investor Enthusiasm Is Finally Bubbling

The past two months have been characterized by a substantial re-awakening of investors’ animal spirits — a positive for the market in the short-term, but a fairly reliable indicator that the odds of a correction are rising.

The growing enthusiasm for stocks was borne out by the data in two key reports that came out late last week. On Thursday, Bespoke Investment Group noted that the American Association of Individual Investors poll had reached its highest level of bullish sentiment[1] since February 2011. The next day, CNBC reported that after a year of strong outflows for equity funds in 2011, investors finally began to move money back into stocks. According to Bank of America Merrill Lynch, investors poured $22 billion into stock funds and ETFs[2] during the weekly period ended Jan. 9 — the second-largest one-week inflow in history. The highest inflow occurred in September 2007 … one month before the pre-crisis high.

These trends aren’t necessarily an immediate negative, since positive sentiment can continue to drive stocks higher as long as the headlines cooperate. However, it does indicate a higher level of public participation — a traditional contrary indicator for stocks.

#2: Risk-on to the Extreme

While market internals are showing that investors have been embracing risk since the November low, this trend has reached a level that might indicate it’s time to take some money off the table.

The first sign that investors might be getting ahead of themselves is the tremendous outperformance for companies that the market had given up on just a few short weeks ago. Some of the worst-performing stocks through the first three quarters of 2012 have delivered colossal returns since mid-November, as shown in the table below. While many of these stocks have jumped on company-specific news, the broader trend is undeniable:

Green Mountain Coffee Roasters GMCR[3] 75.82%
Nokia NOK[4] 72.79%
Research In Motion RIMM[5] 54.27%
Pandora Media P[6] 49.73%
Facebook FB[7] 43.08%
Advanced Micro Devices AMD[8] 42.78%
First Solar FSLR[9] 37.68%
Hewlett-Packard HPQ[10] 24.69%
Netflix NFLX[11] 24.31%

The move in favor of lower-quality and/or troubled companies is reflected in the massive outperformance of high-volatility stocks compared to their lower-beta counterparts. Since the Nov. 15 low, the PowerShares S&P 500 High Beta Portfolio (NYSE:SPHB[12]) has gained 16.22%, versus the 6.01% return of the PowerShares S&P 500 Low Volatility Portfolio (NYSE:SPLV[13]).


This same trend has played out across the market spectrum. While the SPDR S&P 500 ETF (NYSE:SPY[15]) has returned 9.15% since Nov. 15, the iShares Russell Microcap Index Fund (NYSE:IWC[16]) has surged 15.68%. Again, this is the type of move that can carry on for quite some time, but it’s yet another signal of just how much the recent rally has marked a departure from the fear market of 2012.

#3: When the VIX Is Low …

All of these trends are positive signs, of course, but in the context of the ultra-low VIX, they take on a more ominous tone. The volatility index has dropped into the mid-13s, its lowest level in nearly a decade.

Granted, this is justified by low realized volatility, and the VIX futures contracts for February and beyond are indeed showing a greater degree of fear in the market. Still, a VIX in the mid-13s is worrisome since it puts the index deep into the range that typically presages weakness in the stock market.

Bottom Line

Alone, any of these factors aren’t sufficient cause for concern. But together, they paint a picture of a market in which investors aren’t paying much attention to the risks. These indicators are indicating that extreme caution is warranted here, especially in light of the fact that the debt ceiling still needing to be resolved within the next six to eight weeks.

Consider using any additional upside as an opportunity to take profits or buy protection.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.

  1. highest level of bullish sentiment:
  2. investors poured $22 billion into stock funds and ETFs:
  3. GMCR:
  4. NOK:
  5. RIMM:
  6. P:
  7. FB:
  8. AMD:
  9. FSLR:
  10. HPQ:
  11. NFLX:
  12. SPHB:
  13. SPLV:
  14. [Image]:
  15. SPY:
  16. IWC:

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