Even though equity prices continue to increase, driven by sentiment at least as much as fundamentals, analysts continue to be bullish. A number of metrics that identify investor sentiment are high but “not yet extreme,” according to Morgan Stanley (NYSE:MS) analyst Ronan Carr, signaling that we could be reaching a peak. Carr cautions investors against putting too much new money into equities and identifies what could be the catalyst for a downward correction – falling liquidity.

Sentiments suggest bullishness is elevated

“A selection of technical metrics are trading at (or were quite recently at) very high levels versus the last five years – RSI, Bollinger Bands and share price breadth metrics, in particular,” writes Carr. “Some sentiment and positioning metrics suggest bullishness is elevated. Derivative market indicators suggest a very subdued demand for protection. Hedge funds in Europe are at maximum net long (versus last 5 years), and net speculative positions in NASDAQ futures are high.”

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Breadth indicators

Breadth indicators show that 7.5% of stocks are 20% or more below their 52-week high, and while you would expect a low percentage during a bull market, the indicator hasn’t been this low since the last bull market peaked.

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Put-call ratio

The put-call ratio is also at the low end of its five-year range, though it hasn’t yet fallen further than we’ve seen at other times during the crisis. The difference is that people don’t necessarily need to protect their investments when they think the market is at a cyclical low. For the ratio to fall so low when the market is soaring indicates strong investor sentiment.

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Overbought stocks

Carr notes that value stocks, cyclicals, small and mid-caps, telecoms, and financials all appear to be overbought, while only defensive materials and energy stocks appear oversold. “While we maintain an overweight stance in equities, we would be wary of injecting fresh funds in equity markets here. We believe investors should be particularly watchful for any deterioration in liquidity flows,” writes Carr.

It’s interesting that reticence about injecting more cash into the stock market could result in the lower liquidity that Carr warns investors to watch out for. If everyone decides that now is the time to sit and wait, falling inflows could themselves spur profit-taking and a dip in prices. It might not be enough to trigger a large drop, but when you look at investor sentiment we certainly appear to be approaching a peak.