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Why some investors say stock-market ‘euphoria’ calls are premature
By MarketWatch | January 17, 2018

Beaten-down investors just beginning to take note of previously ‘most despised’ bull market

The stock market started 2018 where it left off 2017, notching a string of records and cuing a growing chorus of warnings that outright euphoria was finally beginning to set in.

No question, the rally has left sentiment running hot by closely watched measures. And many bulls would welcome a near-term pullback. But skepticism remains over whether recent gains signal the bull market has crossed the line from optimism to euphoria.

“Where we are is that people finally think this is a bull market,” said Richard Bernstein, chief executive officer and chief investment officer of Richard Bernstein Advisors.

In other words, after nearly nine years many long-skeptical investors are finally beginning to take notice of a post-financial crisis bull market that had previously been described as the most hated in history. But that doesn’t mean investors are yet stampeding into the market in the fashion that has marked other bouts of euphoria, he said.

‘Die on euphoria’

The term euphoria carries import, thanks to the late John Templeton, the legendary investor whose description of the four phases of a bull market are cited regularly by investors and analyst Templeton, in 1994, observed that bull markets are “born on pessimism, grow on skepticism, mature on optimism and die on euphoria.”

It’s a handy observation, but it only gets investors so far. After all, if it were as simple as following along on a program, calling tops and bottoms in the market would be easy. Instead, every bull market is unique. Investors can and do argue over which phase the market might be in at any given time, and shifts can often appear obvious only in hindsight.

The stock market’s accelerated gains in 2018 are certainly attracting attention. The S&P 500 SPX, +0.94% is up around 4%, and began the year with a string of six straight record closes.

For investors who fear the market might be in the early stages of euphoria, the telltale signs include sentiment indicators, which have hit unquestionably elevated levels. The Investors Intelligence survey of professional investors showed bullish sentiment at 66.7%, according to FactSet, up from 64.4% a week earlier and matching a reading from early November that as the highest since early April 1986.

The American Association of Individual Investors weekly survey released last Thursday showed optimism among individual investors pulled back from the previous week but remained “unusually high,” the AAII said.

Bullish sentiment, or expectations stock prices will rise over the next month, fell 11.1 percentage points to 48.7%, after a week earlier rising to its highest level in more than seven years. It remains above the historical average of 38.5%. Bearish sentiment rebounded by 9.5 percentage points to 25.1% a week after notching its lowest reading in more than three years. The average reading is 30.5%. Neutral sentiment came in at 26.3%, up 1.6 points and off the long-term average of 31%.

Overwhelming bullish sentiment is viewed as a contrarian indicator. And market bulls acknowledge it could spell the potential for a near-term pullback. But sentiment aside, they argue that there’s a difference between sentiment and investor actions.

While optimism is unquestionably showing some extremes, not all behavioral measures suggest the same sort of optimism, said Liz Ann Sonders, chief investment strategist at Charles Schwab, in a phone interview.

Watching the flows

A look at overall fund flow data, combining exchange-traded funds and mutual funds, show investors haven’t been piling unrestrained into equities. In fact, on a net cumulative basis, no new money has been added to the U.S. equity market since before 2008, she said.

And while data show that overall household equity exposure is at a very high level and cash levels are low, she notes there has been substantial interest by U.S. investors in international equities. Also, existing exposure to U.S. equities has risen as a result of the market’s continued appreciation.

So while investors are undoubtedly more upbeat, “I think it’s a stretch to say we’re in or entering into the sort of euphoria stage that historically has marked major tops,” she said.

The tide may be turning. Flows into U.S. equity ETFs and mutual funds totaled $24.4 billion over the past week, the sixth largest on record, according to analysts at Bank of America Merrill Lynch, who wrote that “the bull capitulation begins.” Investors also piled into other assets perceived as risky.

Speaking of capitulation, there are also signs investors are throwing in the towel on defensive and bearish strategies.

‘Melt-up’ worries

Some high-profile investors see potential trouble on the horizon. Jeremy Grantham, founder and chief investment officer of Boston-based asset manager GMO, earlier this month laid out his case for a near-term “melt-up” in the next six months to two years that would mark a stock-market bubble and set the stage for a subsequent “meltdown.” Grantham said the S&P 500 would need to rise to “around 3,400 to 3,700” over the next 9 to 18 months in order to resemble a “classic bubble.”

At the same time, however, Grantham said there were “not nearly enough signs of euphoria were yet present to make this look like a late-stage bubble,” but added that, in his opinion, “they have finally begun to pick up in the last two or three months.”

A near-term melt-up could indeed lead to what many investors see as a long overdue pullback, but wouldn’t necessarily mark the end of the bull market itself.

Jeffrey Saut, chief investment strategist at Raymond James, said the stock market’s recent upside push isn’t out of whack with past episodes. The rally form the November 2016 low through the end of last week marked a roughly 42% rise for the Dow. The March 2009 to April 2010 rally saw the blue-chip gauge rise around 83%, while the October 2011 to May 2015 run took the Dow up by 98%.

Meanwhile, a stock market pullback would be healthy for a number of reasons, including the prospect of dampening sentiment, Sonders said.

Meanwhile, investors should avoid taking on stock-market exposure beyond their normal allocation, maintaining diversification and rebalancing when appropriate, she said.

‘Nowhere near’ 1999

While the string of stock market records, perhaps reinforced by tweets from President Donald Trump taking credit for the latest gains, appears to have attracted more mainstream attention, general interest in equities still appears restrained compared with past stock-market peaks.

“If you were in this business in 1998 and ‘99, you saw people quitting their day jobs to day trade,” Saut said in a phone interview. “We’re nowhere near that. The average retail investor is not participating to that degree.”

The bursting of the tech bubble in 2000 followed by the stock-market collapse that accompanied the bursting of the housing bubble, precipitating the 2007 to 2009 financial crisis is thought to have left many would-be investors bruised and wary.

As for whether the current bull eventually ends on a bout of dot-com style euphoria, of course, remains to be seen.

It’s possible that those episodes created a “scarred” generation of investors, Sonders said. And if so, it isn’t clear exactly how the current cycle will end. It might not take a return to the extreme euphoria of the dot-com bubble.

“Maybe this bull market will end with not much more than acceptance,” she said. “Every cycle is a little bit different.”

“The data do not say that investors are euphoric,” Bernstein said. “We are not at the point where yyou see end-of-cycle excitement.”

https://www.marketwatch.com/story/stock-market-runs-hot-but-is-it-really-euphoria-2018-01-17

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