From Healthy Re-set to Negative Feedback Loop
The weight of the evidence reflects broad deterioration and shows that risks exceed opportunities
A casual review of investor sentiment charts (like the one below) shows that when stock prices are elevated optimism tends to soar and when prices come under pressure, investors turn bearish. But a closer look introduces new perspective on the relationship between price and sentiment. In times of strength, optimism can stay elevated for extended periods, oscillating between excessive levels and healthy resets in sentiment. In bull markets, optimism bends but doesn’t break. Price weakness accelerates when sentiment breaks down and bulls head for the exits. That is the negative feedback loop we are seeing emerge in the data right now.
The break-down in sentiment coincides with broad market deterioration that leaves the market in no-man’s land. Bounces are always possible but we have not seen the typical signs of exhaustion and capitulation that suggest a sustainable low is in place. For example, too few sectors find themselves still above their 200-day averages to expect strength quickly re-emerge, but it is too many to to suggest we are in “it is so bad, it is good” territory.
While the breadth thrust regime that emerged last May remains intact, it is running on fumes. With more stocks now making new lows than new highs for 12 days in a row and still counting, the trend in net new highs has rolled over. When this has happened in the past, the S&P 500 has experienced a significant contraction in returns and a sharp expansion in volatility. That could further weigh on sentiment and exacerbate the negative feedback loop.
Returning to the sector situation, while long-term trends are deteriorating, shorter-term trends are firmly in negative territory, with the notable exception of the Energy sector (which only accounts for 3% of the S&P 500). The five largest sectors in the index (accounting for nearly 80% of the index) have trend scores that are already at their negative extremes.
Overall, the weight of the evidence now tilts toward risk and away from opportunity. This reflects an unusually large shift over the course of a single month, but then a lot has happened in the market and around the world over the past four weeks. We will take a closer look at some of the details after the break below.
