DAY HAGAN RESEARCH UPDATE
SENTIMENT STARTING TO REVERSE
Overbought funds are consolidating in narrow ranges as sentiment starts to weaken.
December 21, 2016
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Investor sentiment, often defined as optimism and pessimism, has been a clear driver of the markets since the U.S. Presidential election. Below is a chart of short-term trading sentiment (lower clip in red), versus the S&P 500 index. As shown, sentiment is starting to reverse from the optimistic peak it made last week. While this shouldn't be considered an outright sell signal on the market, it is a warning sign suggesting that overbought areas of the market may be soon encountering headwinds.
In addition to excessive optimism for stocks, we have seen the exact opposite investor sentiment when it comes to long-term U.S. Treasuries. As shown on the chart below, "Relative Sentiment" shows that stock optimism is relatively high versus bond sentiment, which is excessively pessimistic.
If you have spent any time watching or reading the popular financial press over the past several weeks, you can surmise that such euphoric feelings for stocks (and pessimism for bonds) has been deemed the "Trump trade." Ever since the election, investors have rushed into financial, infrastructure, energy and material stocks, pushing many of the ETFs that hold these securities to overbought extremes. On the flip side, bonds have sold off in the hope of economic strength and higher interest rates over the next several years, pushing bond sentiment to extremely pessimistic levels (below).
There are multiple market polls, liquidity-adjusted put/call ratios, and volume indicators available to gauge overall investor market sentiment for broad indexes. But it gets a little trickier when trying to evaluate sentiment levels for exchange traded funds (ETFs). For ETFs, we use underlying stock sentiment, flows into ETFs (new creation/redemption of shares), and overbought/oversold indicators to evaluate an ETF's attractiveness. Typically, we want to consider owning funds where sentiment has gotten extremely pessimistic and avoiding or reducing exposure to funds when sentiment reaches optimistic extremes. Below are some of the charts we are monitoring for extreme readings in sentiment—which could cause us to take positions in our portfolio consistent with the sentiment readings.
Consensus opinion is that financial stocks, and regional banks in particular, will benefit from higher interest rates and the possibility of less regulation in the upcoming Trump administration. Regional banks have been doing well all year, but their move really accelerated after the election. As shown below, such euphoria has pushed the regional banks ETF (KRE) into overbought territory. Like other sentiment indicators, we would go with the flow on this indicator until it starts to reverse.
However, while investors may be enthusiastic, insiders of the bank shares held in this fund are not. As shown below, net insider selling has fallen to -67%, illustrating that there are far more insiders selling their shares than buying them.
Finally, if we look at investor flows into KRE, you'll see that there has been net selling this month, clearly not an endorsement of confidence. Flows in this calculation are based on new creations/redemptions. Since these creation units are typically done in large blocks (50,000 shares or more), we view this as a measure of institutional buying and selling. In sum, KRE is overbought, insiders are selling and we have seen net outflows so far this month. Our assessment would be that KRE, like the sentiment on the broad equity markets, has reached an extreme in optimistic sentiment, and is starting to reverse. Keep in mind that as the indicators change, so do we. We would look to own a fund like KRE once the euphoria has worked off.
In addition to regional bank ETFs, we are seeing similar excessively optimistic sentiment readings from broad financial ETFs, insurance ETFs, industrial ETFs and some smaller-cap oriented funds.
While there are several areas of the market showing optimistic extremes, there are just as many areas where investors are pessimistic. As discussed earlier, bonds and bond ETFs are one standout area where we can see several signs of investor pessimism. As shown below, MUB, a muni bond ETF, is now trading at oversold levels. But we have still not reached extremes we saw back in 2013. So once again, we are waiting for a reversal in several of the fixed-income ETFs.
Like municipal bond ETFs, several corporate bond ETFs are trading at oversold levels. However, if you look at the aggregate flows into 86 corporate bond ETFs, you'll find that institutions have net buyers since November, despite the prospects of higher rates and a stronger stock market. This one area looks attractive from a sentiment perspective.
As we have outlined in previous posts, we think that emerging markets may offer the best opportunities in the New Year and beyond based on economic growth prospects and valuation. And while currency weakness has had a negative impact on several dollar-based ETFs, that pressure is subsiding. As shown below, we started seeing positive flows back into emerging market ETFs this month.
Overall U.S. market sentiment is showing signs of reversing and weakening from optimistic extremes. Should sentiment reach levels indicating excessive pessimism, we would view it as providing a potential opportunity to increase our overall allocation to domestic and international ETFs. We note that fixed income sentiment is very pessimistic and tangentially suggests lofty expectations for U.S. economic growth in the years to come. At this juncture, we are not convinced that bonds have fully entered a cyclical bear market and are actively looking for opportunities in fixed income.
We continue to look at the markets from a multifactor approach and, while sentiment is only one component, it is certainly one of the main drivers of the market at this time.
Have a wonderful week,
Day Hagan Investment Committee Consultant
Day Hagan Asset Management
— Written 12.20.2016
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