While we have been bullish on the outlook for stocks for most of the past five years, we are getting more concerned about the short-term outlook for stocks given the growing overall ‘complacency’ among investors.   Legendary investor Warren Buffett advises to “be fearful when others are greedy, and be greedy when others are fearful.”  While sometimes it is hard to tell which emotion is dominating the outlook, we do have a series of indicators we use to try to measure the level this overall level of ‘consumer sentiment.’   The problem it brings to our attention is that most of these indicators are currently at very ‘excessive’ levels that have roughly coincided with market tops in the past. 

One indicator comes from the bond market where credit spreads are narrowing, meaning that investors have very little fear about corporations missing interest payments.  The spread between corporate and government bonds has hit lows not seen since early 2007, not long before the market peak.  While extremely low interest rates is forcing investors to look for the higher yields from corporate versus government bonds, the yield on so-called ‘junk bonds’ has dropped below 5% for the first time.  Investors are not getting adequately compensated for the higher risk inherent in those lesser-quality issuers.

Another good indicator of investor sentiment is the Volatility Index, or the VIX.  This index remains near cycle lows suggesting very little overall worries about the stock market.  While a low VIX has never been enough to push a market into correction, it has occurred in advance of major market declines.  The last time the VIX was in this range was in early 2007, more than a year before the market collapse in 2008.   However, at 12.0 today, it is a long way from the peak level of over 44 it saw at the stock market lows in early 2009.  So while it’s not pointing to imminent danger, its nowhere near indicating we are early in this stock market advance.  More worrying on the sentiment side is the Investors’ Intelligence survey, which pegs bullish sentiment at more than 60%, a level not seen since October 2007, the week the S&P500 hit its pre-bear market peak.  While bullish consensus is near the high, the bearish number in that same survey has dropped to a five-year low, further indication that investors are just a little ‘too comfortable’ with the outlook.

While the valuation of stocks on an earnings basis are only slightly above historical averages, the “total-market-cap to GDP ratio,” an indicator Warren Buffett uses to gauge markets, is at an all-time high of 118%.  This ratio had only hit the 100% level twice before.  The first time was in 1999 and the last was in 2007.  Both prior occurrences were at stock market peaks!  Another worry is that a few of the very bullish indicators we have relied on for the past few years to support a positive outlook for stocks are no longer as supportive.  Cash levels at corporations had risen to all-time highs following the last recession as companies hoarded their cash balances to mitigate financial market risks.  We liked the idea that this cash was then available to increase dividends, buy back stock, expand business or engage in acquisitions.  All of those activities have acted to reduce cash balances; corporate cash as a percentage of the market value of the broad Wilshire 5000 stock index has dropped from a peak of over 100% in 2009 to under 50% today!  The argument that companies have excess cash to spend is certainly not as strong as it was.  Even more worrying, though, is the fact that Margin Loans in the U.S. have exploded to the upside.  As a percentage of GDP, the loans that primarily fund stock market purchases have risen to almost 2.8% versus a low of 1.2% at the market bottom in 2009.  Once again, the last two times we saw Margin Debt at this level were at the market tops in 2000 and again in 2007.  Investors love stocks and are buying them with borrowed money; now that’s something to worry about.

While we don’t like making trading calls because the stock market does not always act rationally in the short-term and sentiment alone isn’t usually sufficient to stall a bull market, we can’t help but be a bit concerned that stocks have come a long way over the past five years and that future gains will be more constrained.  We have reduced our equity exposure accordingly and are now underweight stocks for the first time in three years.  While we still think that we will see higher stock prices over the next 3-5 years as the global economic recovery continues, our ‘trader’ side is clearly more concerned about the shorter-term outlook.  However, a 5-10% ‘correction’ in the stock market would probably be enough to move us back to an overweight position!

Sentiment indicators were the biggest downgrade in our proprietary ‘Five Factor Asset Allocation’ model shown below. Each of the five ‘macro’ indicators is ranked from -2 to +2 with the total score falling between -10 (most bearish outlook for stocks) and +10 (most bullish).  A zero score generally means we would be ‘neutral weighted’ in stocks.  The indicator has dropped over the past two years as stocks have rallied, from +5 in October, 2012, to +2 last November.  The most recent update puts it at -1, the first time it has been below zero in three years and is the primary reason why we have gone to a short-term underweight position in stocks.Asset Mix Indicator Turns Negative

The good news is that most of the downgrade came from the Sentiment Indicators, which dropped to -2.  This indicator can change most quickly and we would expect to see sentiment change dramatically if stocks were to undergo a 5-10% correction.  Also, the Stock/Sector Valuation Indicator is only slightly above fair value and would also fall back into ‘buy territory’ with a correction of that magnitude.

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