Bulls Get Another Reason to Worry As Sentiment Gauge Flashes Red

Stock bulls have another reason to worry that the blistering rally in American equities may be about to cool.

The Bloomberg Intelligence Market Pulse Index pushed to a “manic” reading last month, a sign that investor exuberance may be running too hot. The measure combines six metrics like market breadth, volatility and leverage to deliver a reading on investor sentiment. When it gets into overheated territory, returns tend to weaken in the following three months.

The Pulse index’s rise comes after the S&P 500 rallied almost 30% from its April low even as the American economy and labor market have shown signs of weakening. Surveys of investor sentiment indicate bullishness is growing toward alarming levels among Americans. And just this week, Wall Street strategists issued a slew of warnings that equities could face a pullback.

“Risk taking in the stock market has gotten a bit overheated, so more muted returns may be in store in the next few months,” Michael Casper, senior US equity strategist at BI, said by phone. “But this doesn’t necessarily signal a major selloff is imminent. Sentiment could hover at these levels for awhile, which may lead to a bumpier path for stocks in the second half of the year.”

The S&P 500 notched its worst week since May last week before dip buyers stepped in to deliver its best one-day gain since that same month. The index slipped 0.5% Tuesday.

BI’s Pulse index hit 0.6 in July for the second straight month to push it into the “manic” zone. Over the past 30 years, the Russell 3000 Index — a crucial benchmark of the virtually the entire US stock market — has averaged just a 2.9% return over the next three months, according to data compiled by BI’s Casper and Gillian Wolff. When the gauge swings into what BI dubs “panic” territory, the Russell 3000 averages a 9% gain in the next 90 days.

The index signal jibes with recent warnings from a host of Wall Street strategists. Morgan Stanley’s Mike Wilson sees a correction of up to 10% this quarter, while Evercore’s Julian Emanuel is expecting a drop of up to 15%. A team at Deutsche Bank notes that a small drawdown in equities is overdue.

Added to bulls’ worries is seasonality. August and September have historically been the two worst months for the S&P 500. Friday’s jobs report showed the labor market cooling, while a private reading on the American services sector on Tuesday signaled a slowdown in output and an increase in price pressures — all while President Donald Trump pushes ahead with tariffs that are the highest since 1934.

The Pulse index has been a reliable harbinger of market performance in recent years. The readings hit “panic” levels ahead of the March 2023 regional banking crisis, the December 2018 tariff-induced slide and the 2012 European Union debt crisis.

Among the reasons for the latest “manic” reading were was the re-emergence of the meme frenzy in late July, with retail traders snapping up speculative stocks like Opendoor Technologies Inc. and Kohl’s Corp.

Of course, sentiment can stay frothy for weeks — even months — before stocks suffer a significant drop. It hit a manic reading during January 2021’s meme craze but hovered in that territory for over a year before the S&P 500 slumped into a bear market.

Perma-bull Ed Yardeni of eponymous firm Yardeni Research noted that not all signs are ominious. In the week through July 29, a ratio of bulls to bears identified in an Investors Intelligence survey of newsletter writers hovered at a ratio of 2.4, below a long-term average of 2.6 over the past decade, Yardeni Research analysis shows.

“In other words, sentiment wasn’t overly bullish,” Yardeni wrote in a note to clients on Sunday. “Rather than yet another correction this year, we are more likely to see seasonal choppiness.”

BI’s Market Pulse Index is based on six inputs: price breadth, pairwise correlation, low-volatility performance, defensive-versus-cyclical performance, high-versus-low leverage performance and high-yield spreads. The major difference last month was that high-yield spreads were manic in July, joining high versus low vol performance in that territory.

The Market Pulse Index ranges from 0 to 1, with the latter denoting periods of risk-on sentiment, or extreme “mania,” as BI defines it, while a level close to 0 shows a risk-off period of extreme “panic.” In July, the indicator rose to nearly 0.7 — approaching a mania stage.

Generally, two repeat readings above 0.6, like now, suggests there will be some mean-reversion activity in the equity market over the next three months, with small caps underperforming their larger counterparts, according to Casper. In fact, three months after a manic reading, the small cap Russell 2000 Index historically has underperformed the S&P 500 by 1.8% after such a figure.

“Stocks have come a long way in a short time and things seem stretched,” said Adam Phillips, managing director of portfolio strategy at EP Wealth Advisors, whose firm is neutral US equities and is snapping up dividend-payers like energy, financial and industrial shares. “We’re not chasing this rally or stepping on the gas pedal.”

Source: Bloomberg Europe