Jason Goepfert at SentimenTrader—the definitive source for sentiment data on stocks, bonds, and commodities—has been tweeting out a few warnings signs regarding “excessive optimism” in the stock market, so we decided to have him back on Financial Sense Insider for an update.
The last time we spoke with Jason Goepfert was in May of 2015 where he explained that most sentiment measures were showing investors to be all in. This meant, he believed, that returns for the stock market were likely to be weak with a much higher risk for a correction in the months ahead. To Jason’s credit, that’s exactly what happened. The S&P 500 put in a high that month around 2130 before suffering two steep corrections months later.
Jason is now saying that some of the same patterns of optimism are appearing, which could pose a headwind for the stock market in the months ahead. Here's a clip from last week's interview where he explained what's giving him caution:
Sentiment Signaling Short-term Risk
Sentiment is useful for trying to gauge risk versus reward, and in the May 2015 time frame, the risk was quite high relative the potential upside. Now, we’re in a somewhat similar situation, he said.
This starts to become apparent from a sentiment perspective if we look at Rydex mutual fund traders, which, as he mentioned in the clip above, are “extremely bullish”.
“Overall, they’ve got about $14 invested in bullish index funds for every $1 they’ve got in inverse funds that would profit on a market decline. Just in the past few days, that moved to an all-time record.”
We would have to go back to March 2000 to see the next highest peak, then around a $13-to-$1 ratio. While the indications from this group’s behavior aren’t perfect, it has worked for 20 years, Goepfert noted.
“Clearly we’re seeing really high optimism among these traders,” he said. “It’s really the optimism behind that—the sentiment behind that—that’s probably transferable to the broader market. For us, that’s a very troubling sign.”
Other Warning Signs
This alone doesn’t signal trouble ahead. Rather, we need to look at other sentiment indicators for confirmation, Goepfert noted.
As it turns out, a few others have popped up: for one, he looks at hedge fund exposure to the stock market, which is also at an extreme.
“Right now, (hedge fund exposure) is at a very high level,” Goepfert said. “In the past, when we’ve seen that — and it’s only been this extreme a handful of times — stocks have declined over the next 1 to 3 months.”
This, incidentally, is the time window Goepfert focuses on, where the indicators he uses are most effective. Another indicator is the behavior of small options traders, who have been extremely apathetic about this bull market...until now, Goepfert stated.
“When we see signs like that, across very different indicator groups that are all saying basically the same thing, that’s when the bell starts to ring and we start to get really nervous,” he said.
Though short-term risk for the stock market as a whole is higher than average, Goepfert told FS Insider listeners the various areas where sentiment is providing bullish signals.
In some cases, particularly in the agricultural commodities sector, sentiment is at multi-year or even multi-decade extremes, he noted.
“Smart money traders...have gone long many of these markets...and that's extremely unusual.”
From a risk vs. reward standpoint over a multi-month time frame, this is where the most bullish readings are coming from currently, Goepfert said.