Wised-up market watchers are quick to sneer and jeer when small investors start to cheer a stock rally.
And cheer they did last week, reacting to a clear election result and encouraging news on Pfizer's Covid-19 vaccine trials with an emotional burst of buying at Monday's open, the largest inflow for equity funds in years and one of the biggest jumps in retail-investor optimism on record.
Given that the crowd is known to be wrong at extremes, skeptics last week quickly seized on this evidence that the public perceived "All clear" as a warning that fuel for further market gains was running low.
There's no doubt that investors who had stayed in a defensive crouch ahead of the "known unknowns" of the presidential election and vaccine-development efforts before finally grabbing for stocks last week on what seemed like a moment of clarity ended up buying much higher than they could have.
When the S&P 500 opened higher by some 3% to start Monday, it was 11% above than it closed just ten days earlier, when all the talk was of "uncertainty" and downside risk. And this, just two weeks after we made the case that investors were fearful enough to set up a late-year rebound attempt. One can understand folks want in on a fourth-quarter rally, but the S&P is already up 6.6% this quarter, more than the average gain for the October-December period.
Yet just because they paid up for having waited doesn't mean they bought a market top.
The history of such sudden bursts of relief among the public shows they're not typically the greatest entry points but also far from automatic rally killers.
Nearly $45 billion in net inflows rushed toward equity funds in the latest week, which Bank of America calls an all-time record.
As the chart here shows, the last comparable intake was in January 2018, a month when a furious rally crested in the afterglow of a long-awaited bullish catalyst, the passage of the Trump tax cut weeks earlier. The market soon skidded into a jarring correction, then a choppy sideways phase, before returning to those highs within months.
Bank of America global strategist Michael Hartnett sees these flows as well as the synchronous surge in global equity markets to overbought extremes as a hint of a culmination process for this advance getting underway.
"We are sellers-into-strength into vaccine," he says, based on "peak positioning, peak policy, peak profits likely coming months," comparing it to the 2018 pattern.
Is it a market top?
Members of the American Association of Individual Investors have been among the more stubborn groups in mistrusting the market since the March bottom with below-average bullish sentiment in the group's weekly for a record stretch – until last week.
Bulls in the survey, which runs through Tuesday each week, jumped from 38% to 55% - also the highest reading since January 2018. The history of similar jumps in AAII bulls since the survey started in 1987 show somewhat below-average – but still positive – S&P 500 returns in the coming months.
SentimenTrader, a research service that analyzes the market implications of investor attitudes and behavior, looked at prior dates when the AAII bullish percentage jumped more than seven percentage points and more than $7 billion went into equity funds.
The combination of factors top-ticked the 2003-2007 bull market, but aside from that these were not particularly bad times to be buying stocks, with respectable forward returns extending out six months to a year.
In other words, when investors get enthusiastic, it can mean the market is due to cool off a bit and perhaps becomes less able to shake off scary headlines. But it doesn't pay to immediately assume a bullish public will automatically be proved wrong. Not every rally is hated, not all upside progress happens in ironic repudiation of the consensus, not every trade is the "pain trade."
Another overshoot like June?
Admittedly, the market's strength last week in other ways seemed incongruous. The gains were distinctly led by cyclical stocks geared tightly to a reopened economy, even as the daily news flow was of an alarming Covid-case surge and re-imposed business restrictions and social-distancing orders.
A buyer of Monday's opening pop with the S&P 500 over 3600 for the first time is still underwater even as the S&P gained more than 2% on the week, as that buying frenzy faded and the huge growth stocks that dominate the index fizzled.
Monday was the single worst day on record for the momentum investing theme, and money overall flowed from growth to value, large stocks to small, stay-at-home plays to back-to-work names, year-to-date winners to laggards and defensive to cyclical.
If the market's message can be taken at face value, then it's encouraging for the economic outlook and supportive of the equity rally. But the day-to-day action was erratic enough – looking at times like automated investment-factor pinball – that it's tough to say for sure.
Can these shifts be read as the market resolutely looking beyond the immediate slowdown threat of a winter virus outbreak toward a moment in early 2021 when treatments and vaccines liberate the economy? Or was this another overshoot of reopening enthusiasm as we saw in early June before a market setback and a return to the shelter of the mega-cap growth darlings?
This is the debate last week set up for investors to engage over the coming weeks.
Aside from sentiment and equity flows getting a bit giddy, the market's underpinnings are hard to fault too much. The rally has been broad in recent weeks, showing urgency by buyers, though this is most predictive of strength beyond the next month or so.
Earnings forecasts for early 2021 are on the rise and the S&P's multi-month sideways churn has allowed profits to do some catching up to prices, leaving the market looking not cheap but a bit less richly valued than in midsummer.
It's tough for stocks to encounter too much lasting trouble when credit markets are strong enough that junk-bond yields fell below 5% for the first time. Frothy, perhaps, but free of financial stress.
And of course, seasonal patterns are favorable — which doesn't necessarily change just because most investors are now in a full sprint, intent on catching a year-end rally.