Macro Minutes: Sentiment in Market Cycles

Title screen appears, “Sentiment in Market Cycles”

Presented by:

Raymond Chen, Fisher Investments Capital Markets Innovation Research Analyst, on behalf of Fisher Investments and its affiliates.

A man appears on the right side, down corner of the screen wearing a navy suit, sitting in an office. He begins to speak.

A banner identifies him as Raymond Chen Fisher Investments Capital Markets Innovation Research Analyst, on behalf of Fisher Investments and its affiliates.

Raymond Chen: My name is Raymond Chen and I work on the capital markets innovation team in Fisher Investments Research Group. In this video, we'll discuss how investor sentiment evolves through the market cycle, provide some examples of how we track sentiment, and importantly, share our views on where investor sentiment is today.

A white screen appears showing a chart with the image of sir John Templeton’s quote” Bull markets are born on pessimism, grow on scepticism, mature of optimism and die on euphoria.”

The chart is showing how the market start bearish at first, then goes on a bullish rally that ends up in a bearish euphoria.

Raymond Chen: Sir John Templeton, one of the 20th century's most prominent investors, famously said that bull markets are born on pessimism, grow on scepticism, mature on optimism, and die on euphoria. At the beginning, markets recover from the depths of a bear when investor sentiment is more pessimistic than appropriate, given the improving strength of the economy. As conditions improve, those worries gradually fade and sentiment moves from overall scepticism to optimism, enticing more previously timid investors back into the market. As the bull market matures into its late stages, investors start to forget or underappreciate any prior worries, and optimism builds into euphoria. Eventually, reality can't possibly match sky high expectations, and the stage may be set for a negative surprise in a bear market.

The white screen appears to change into 3 charts titled “Sentiment Progression Directly Influences Returns” the subtitle is: “Using the Templeton Framework, We See Key Differences at Each Stage of the Cycle”

The charts are showing different stages traders go through, it starts with pessimism, scepticism, optimism and Euphoria.

Raymond Chen: Now, understanding sentiment's evolution is a critical part of our investment process because it directly influences market returns. The chart on the left shows the median annualized return for the S&P 500 throughout bull markets, and it's broken up by six-time frames. Highlighted in blue, we notice that returns are frequently positive and their strongest at the beginning and at the end of a bull. We believe that the strong returns experienced at the beginning of a bull are driven by markets continuously trying to close the gap between improving economic fundamentals and overly dower perception. During the bull market's middle stages, when overall investor sentiment is sceptical to optimistic, returns tend to moderate. Investors generally feel more upbeat about the future and are cautiously re-entering the market. And while fundamentals are still strong, media and investors still find plenty of things to worry about, including rising or falling interest rates, slowing GDP growth, oil prices. Really, it can be just about anything. As the bull market enters into its later stages, sentiment is optimistic to euphoric, investors are confident, and they're usually equipped with thoughts that this time is different. Late-stage returns tend to be strong as investors pour more money into the market, and that expands valuations and drives stock prices higher.

Raymond Chen: Now, following sentiment's progression throughout the market cycle also helps to anticipate what types of stocks will outperform at each stage of the bull. The chart on the right is similar to the one on the left, but it shows the relative performance of large cap growth stocks compared to small cap value stocks throughout bull markets. Looking at the red bars, we see that in the early stages of a bull, small cap value companies outperform large cap growth companies. We believe this is rooted in small cap value companies becoming the most unloved companies as a bear market develops, this sets the bar of expectations extremely low for these companies, allowing improving fundamentals to deliver a strong upside surprise at the beginning of a bull market. In green, we see that large cap growth companies outperform during the bull market's late stages. Here, rising optimism and euphoria leads investors to chase new growth stories boosting large cap growth outperformance throughout the end of the bull.

The white screen changes into another chart titled “What Others Get Wrong About Market Sentiment” with a subtitle that read as” There is Ample Groupthink on How to Measure Sentiment”

The chart is comparing forward returns to “price-to-earning ratio”

Raymond Chen: If investor sentiment sounds ambiguous, that's because it can be. Measuring something as dynamic and broad as sentiment presents its many challenges, and we don't ever claim to be able to fully quantify sentiment, and we approach every analysis with a qualitative overlay. Yet, there are a few common pitfalls that we see others get wrong about measuring investor sentiment. First, an over reliance on valuations and mean reversion arguments in an attempt to predict where the market may be heading. One example that we commonly hear is that stocks with high price to earnings or PE ratios must fall back down simply by nature of having a higher valuation than average. The truth is, valuations alone don't tell you where the market is heading. On the right, we show a scatter plot of the S&P 500s year-end PE ratio compared to its returns one year later. Notice the wide amount of dispersion seen at both higher and lower PE ratios. This tells us that there is little to no relationship between PE ratios and future stock performance. Additionally, we see a general overemphasis on investor feelings instead of investor behavior, as well as emphasizing economic surveys over market surveys.

Raymond Chen: As the saying goes, actions speak louder than words, which is why we prioritize investigating investor behaviors such as asset positioning and equity flows over feelings-based assessments. And while economic surveys can be useful, they become a lot more useful when viewed together with market surveys to identify any incongruencies. Remember, markets always lead the economy and not the other way around. The last two pitfalls are arguably the most important a lack of qualitative context and expecting unique results with unique data. A qualitative context includes being able to frame current sentiment readings to identify where we are at in the market cycle. Meanwhile, markets are always moving on the unanticipated, and to gain unique insights requires identifying trends that no one else is looking at or appreciating.

The white screen appears with a table, it’s titled “How Does Fisher Investments Use and Quantify Sentiment?”

It is then subtitled with “A Few Examples of our Quantitative and Qualitative Approach to Evaluate Sentiment”

The table has many headings such as: Behavioral Indicators, Unique Internal Indicators, Qualitative Overlay and Reality vs Expectations.

Raymond Chen: This slide provides a general overview of how we evaluate investor sentiment through a quantitative and a qualitative approach. The upper left table lists a few examples of the many behavioral indicators that we regularly track, such as capital markets activity, margin balances, performance spreads, and positioning. Our behavioral based indicators paint a picture of the market's current activity levels, and they're designed to capture both gradual trends and spikes in activity. In addition, we leverage our global client base of over 100,000 clients for a real time pulse of investor sentiment. The bottom left table lists a few examples of the data points that we regularly analyse, including monthly client survey results, types of client event questions, as well as frequency and magnitude of client additions and withdrawals.

Raymond Chen: Now, earlier I mentioned that markets are always moving on that gap between reality and expectations. The table on the top right lists just some of the ways that we attempt to measure that relationship. One example is our Fisher Investments Guru Survey, in which we gather median annual return forecasts from investment professionals to estimate where consensus expectations lie. Additional quantitative approaches include looking at the ratio of market value to operating cash flow within a sector or a region, or looking at the number of companies that beat or missed earnings expectations. Lastly, all analysis requires a qualitative overlay. The bottom right table lists examples of the questions we routinely ask ourselves to guide our approach, such as are retail investors behaving rationally? And do they believe things are different this time? Very importantly, we ask ourselves, do expectations fit the current stage of the cycle? If there is a large disconnect between economic and sentiment signs pointing to different stages of the cycle, that can be a cause for concern or opportunity.

The white screen changes back again with 4 new charts titled “Examples of Some of the Sentiment Indicators w

We Use” it is then subtitled with “Behavioral Based, Quantifying Expectations and Unique Data From Our Clients”

The 4 charts cover all of Margin debt spikes, Internal client survey – Expected Withdrawals, Market cap vs Flows and 1^st Day IPO returns.

Raymond Chen: Let's take a look at what some of these indicators we just listed off are saying today. The two charts on the left part of the slide are both behavioral indicators. The top left shows a six-month average of US IPO returns on their first day of trading. While the bottom left chart shows how many standard deviations that current margin balances on the New York Stock Exchange fall relative to a rolling three-year average. When these series trend upwards, it may indicate increased level of investor activity and rising sentiment. When investors are euphoric, they start to chase the newest fads and IPOs and are willing to go out further on margin to fuel their market bets.

Raymond Chen: If we look at the recent trends in both series, we see that investor behavior rose through 2019 and parts of 2020, but have cooled down in recent months. The top right chart shows the highest ratio of share of market value compared to share of operational cash flow from a sector or a region in the MSCI All Country World Index. When the trend line is going up, it may indicate a widening gap between unreachable expectations and reality for an area of the market and this might potentially lead into a bubble. As the chart suggests, we don't see any extremes developing currently and we are far away from the peaks that we saw leading into the dotcom bubble in 2000. The bottom right chart comes from our monthly internal client surveys and shows the percent of survey respondents who plan to pull money out from their FI managed account in the next three months.

Raymond Chen: We view this as a contrarian indicator, so when the trendline goes up, it indicates clients feeling more bearish and when it goes down, it indicates clients feeling more bullish. Our recent readings haven't strayed far away from average, indicating a current lack, extreme worry or excitement within our client base.

The white screen appears to switch back this time to a table that was titled “Where is Sentiment Today?”

It is then subtitled with “Summary of our 30+ Indicators”

The table has many headings such as: Behavioral Indicators, Unique Internal Indicators, Qualitative Overlay and Reality vs Expectations.

Raymond Chen: So where does that leave us in terms of where sentiment is today? Our view is that sentiment is late cycle. We think we're in that optimistic phase, but not yet quite at euphoria. When we look at our behavioral indicators, we saw pockets of froth developing earlier in 2020 on positive vaccine news and elevated capital markets activity. However, we've seen a clear and noticeable cool down in investment behavior since the fall of last year. Meanwhile, performance spreads and equity positioning and flows remain far from concerning levels. Overall, behavioral has cooled to where we see optimism mixed with a little bit of scepticism.

Raymond Chen: Our internal indicators read optimistic, but we haven't seen them reach extreme levels of euphoria. We are seeing increased levels of client requests such as instructions to not sell current positions, as well as a noticeable trend in new inbound assets trending less defensive, yet clients still demonstrate a clear level of caution, as demonstrated by an elevated number of bear market questions at client events. On the reality versus expectations front, we see that current expectations are running high, but they are not yet overblown.

Raymond Chen: Current market positioning for the most part matches current economic expectations and we haven't seen any significant areas of excess develop yet. Finally, our qualitative assessment tells us that there has been a surge in retail investor activity over the last year, with fringe assets such as cryptocurrencies and non-fungible tokens gaining popularity. Yet we've noticeably seen a claw back from wide spread optimism this summer as investors wrestled multiple concerns such as the Delta variant, runaway inflation, tax hikes and supply chain issues. These are all just to name a few. And while these are all areas that we are paying close attention to, as markets continue weighing on these fears, consensus becomes less clear and that moderates optimism's ability from brewing into widespread euphoria and in our view, points to more bull market ahead.

The screen changes to a white screen, with the sentence “Thank you for watching! If you would like to learn more about our views, please reach out to your relationship manager or email FisherInstitutional@fi.com”

Raymond Chen: And that's its folks. Thank you for watching this edition of Macro Minutes. If you would like to learn more about our views, please reach out to your Fisher Investments Relationship Manager.

Raymond Chen is finished talking and a series of disclosures appears on screen: "Investing is Securities involves a risk of loss. Past performance is never a guarantee of future returns. Investing in foreign stock markets involves additional risks, such as the risk of currency fluctuations. The foregoing constitutes the general views of Fisher Investments and should not be regarded as personalized investment advice or a reflection of the performance of fisher investment or its clients. Nothing herein is intended to be a recommendation or a forecast of market conditions. Rather it is intended to illustrate a point. Current and future markets may differ significantly from those illustrated here. Not all past forecasts were, nor future forecasts may be, as accurate as those predicted herein.

[music]