Sentiment pulled back slightly this week, but remains firmly in Euphoria territory making a downturn likely in the next year. While increasing equity net inflows provide some price support, there are also signs that investors need to watch out because anything from tapering acceleration to disappointing earnings could be enough of a catalyst for a 1Q correction.

83% historical chance of losses within 12 months

“Our Panic/Euphoria model remained in euphoria territory,” writes Citi’s chief US equity strategist Tobias Levkovich. “This week’s Panic/Euphoria reading was 0.63; versus last week’s revised number of 0.65. Euphoria readings indicate the market may retreat with an 83% historical probability of losses in the next 12 months.”

Citi’s Cyclical Expectation Model (CEM) saw a much sharper drop in sentiment, but this is a short-term indicator signaling that many investors think a small correction may be looming despite being generally bullish on equities this year. At the same time, stock correlations have fallen below 30%, showing that macro is no longer a major concern for most investors.

panic euphoria 0114 Sentiment

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Stocks slightly overvalued, inflows increase

“Our earnings yield gap is now 0.48 standard deviations above the rolling mean, suggesting that equity valuations are modestly overvalued based on this metric,” writes Levkovich.

Despite stocks being expensive right now, the four-week moving average net inflows increased from $1.89 billion last week to $3.90 billion this week. This huge jump is due to an estimated $8.28 billion in net inflows for equities this week ($4.24 billion for domestic funds and $4.04 billion for foreign funds). These flows must give comfort to investors worried about short term drawdowns, since a spike in equities inflows seems like it should provide plenty of price support in the near term, but Levkovich warns that he still thinks investors need to be careful.

normalized earnings yield gap 0114 Sentiment

liquidity money flows 0114 Sentiment

“We continue to think that a 1Q14 correction (in the 5%-10% range) is possible given weakening EPS forward guidance trends and some softening in the Cyclical Expectations Model, not to mention euphoric sentiment levels,” he writes. “With a 1,975 S&P 500 target by year-end 2014 as economic conditions improve this year, we remain generally constructive longer term while continuing to advise nearer-term tactical caution.”