Pessimism is Rampant

Many of us tend to think that others think like we do, that others will
consider the facts and come to the same conclusion we have arrived at.
However, the facts show that is not the case. This is why the forecast of market
experts are consistently accurate less than 50% of the time. It shows that no
matter how smart or experienced we are, it is very challenging to determine how the

masses will react to the situation we are facing. So, rather than analyzing
all the positive and negative factors to come up with a verdict, one of the best
ways to see how the investing public is reacting to current events is to look at
indicators of investor sentiment. After all, it doesn't really matter how good or bad
things are. The perception investors have after considering all of the facts and
emotions is what really matters.

This chart from American Association of Individual Investors (AAII) below
shows how optimistic individual investors in the US have been since 2005. The
black line shows the level of optimism while the blue line is the level of the S&P
500. You can see that the level of optimism was only lower than the level today
during one period, which was the Financial Crisis from 2008 to 2009. The blue
shaded circles show how the S&P 500 acted when optimism was at this level in
the past. You can observe that stock prices were higher within a few months every
time except for the Financial Crisis. At that time, stock prices fell for 18 months
from 2007 to early 2009. This occurred when stocks were in a long-term
consolidation phase.

This week’s survey of sentiment from prominent investment newsletter writers
(from Investors Intelligence) shows that there are 1.2% more pessimists than
optimists. There were more pessimists than optimists for three weeks in a row
during March, which matched the three consecutive weeks of more bears than bulls
in March 2020. You can see that stock prices had a major rebound when sentiment
reached this level in late 2018 as well.

However, there is a significant difference between what is happening now and
what happened in late 2018 and March 2020. In those previous instances, the
Federal Reserve made positive announcements regarding the level of interest rates.
Today, the focus is on how much interest rates could rise. The Fed is also taking
other measures to reduce liquidity. As mentioned in last week’s Update, rising
interest rates on their own are not usually negative for stock prices and the
economy. Even so, it can take some time for investors, business owners and
consumers to adjust to this new reality. Supply shortages caused by the pandemic

and the fighting in the Ukraine are making matters worse for inflation and interest
rates but this is not a surprise. Higher levels of pessimism suggest that investors
are already factoring in the worst-case scenario into current prices. That is why
stocks have corrected from their peaks.

Evidence to support this can be seen from the chart below from J.P. Morgan. It
shows the net flow of funds by US hedge funds for the last four years. The blue
line shows that the movement of money out of stocks and into cash has been as
great this year as it was when the pandemic first spread around the globe in early
2020. Stock prices fell more than 30% in 2020 but declined 15% at the lows this
year. As of today’s close, the S&P 500 is down 9% from the all-time high.

The gray line shows what the four-week returns have been like after fund flows
reached various levels. There are three areas shaded in pink showing that stock
prices rebounded when selling reached these levels. Having raised all this cash
means that these hedge funds will have to start putting this money to work at
some point. Eventually hedge funds and corporate buybacks will almost certainly
provide the fuel to support the next uptrend.

While the current levels of investor sentiment, advisory sentiment, and cash
held by hedge funds indicate that the worst-case scenario could already be
factored into current prices, these factors have not been known to precisely
indicate when a new uptrend will start. In fact, I remember seeing close to 25%
more bears than bulls over a six-month period in 1994 when the S&P 500

corrected by only 10% and remained in a narrow trading range for that period.
Prices did not drop any further. However, such an extreme level of pessimism for
a very long time created the conditions for one of the best bull markets in history
from early 1995 to 2000. What has happened in the past shows that the longer
pessimism lasts and the more pessimistic sentiment becomes just adds more
power to the rally that eventually follows.

The long-term oscillators can be more helpful to narrow down the timing of
market lows. The oscillator for the S&P 500 had a double bottom in January and
February and has rebounded since then, as you can see below.

However, the financial sector has been on a different cycle than the rest of the
stock market this year. These financial stocks have been weak recently. It is hard
for the stock market to have a full pull to the upside when this critical sector is
going in the other direction.

It seems as though the financials made a double bottom only four weeks apart
two weeks ago but prices have not gained much since April 7th. Most double
bottoms occur six to eight weeks apart. That is just how long it seems to take to
eliminate most of the selling pressure. Next Monday, April 25th will be week
number seven since the initial low on March 7th. Perhaps the simple passage of
time will provide the catalyst required to get investors out of the funk they have
been in this year. Please see the oscillator for the US Banking Index on the next
page.

This may seem like a busy chart so just look at the bottom of the chart to see
when the white line has been as low as it is now. It has only been this low five
times since 2012. The financial sector started an uptrend soon after the oscillator
has been this low every time since 2012. The oscillator started to turn up two
weeks ago but took an unexpected reversal to head lower right after that. A lower
oscillator and more time since the first low of the double bottom could be what is
required to get this sector to rebound for the longer-term. (Oscillators are produced
by data from Refinitiv)

In summary, high levels of pessimism and cash at hedge funds indicate that the
risk has diminished. These conditions do not give us a precise time frame for when
stock prices should start a new uptrend. No one knows what the catalyst will be for
the financials to turn around so that all sectors can rise together. Bonds have been
very weak and they are also oversold. The oscillator for the banking sector seems
like it is lower than a snake’s navel in a wagon rut, so there could be a reversal
anytime. Cash from corporate buybacks is also just waiting to be deployed once
confidence returns. All that is needed is a mood change by investors. Sometimes it
happens for no reason after investors have just had enough of being bearish. Other
times there is some sort of catalyst that instantly changes the mood from risk off to
risk on. Either way, the longer pessimism like this persists, the more likely it is that
the rally that follows will be well worth waiting for! In the meantime, patience will
be required.

 

SAR Update

It has become much busier for our team after a very quiet start to 2022. We were
called out for a nighttime mountain rescue of a snow bike, last week, as was
mentioned in my previous Update. A few days later we went from snow and
snowmobiles on the mountaintops to jetskis on the lake. We had a call to check out
what looked like an overturned boat in the middle of the lake, which could be very
concerning if someone was in the cold water. However, it turned out to be a big
piece of Styrofoam that likely came from a dock somewhere. Please see the photo
below. The RCMP has to check all of these types of reports because you just never
know what might have happened. This is just what we have to deal with from time
to time. Of course situations like this never make the news.

We had another call of a missing person who was located in good condition and
then had to recover a kayak that was also floating in the lake. That would have
been reported had it not been removed. More recently we brought a person to land
for a medical condition from where there was only boat access. It is good to get
back into higher levels of service so we can remain a well-oiled machine. Be safe
out there and have a good weekend my friend!