Brad Lamensdorf, the founder and portfolio manager of Active Alts, is a principal and co-manager of the AdvisorShares Ranger Equity Bear ETF. He previously managed a long-short investment partnership from 1998-2005 under the name Tarpon Capital Management. Earlier in his career Mr. Lamensdorf was an equity trader/market strategist for the Bass Brothers’ trading arm. He managed a short only portfolio in addition to co-managing a $1bil hedging program. He also served as in-house market strategist for the entire internal and external network of Bass Brothers money managers.
As the chart below shows, investors have racked up huge margin debt in the hopes of increasing performance in a rising market. But that huge debt overhanging the stock market by a thread like the sword of Damocles means greater risk on the downside. That’s because the heavy use of margin, which often occurs at the end of a bull run, exacerbates the downturn when investors are forced to sell shares to avoid or satisfy margin calls.
We use investor sentiment as contrarian indictors to ascertain stock market direction. Bullish sentiment in the Investor Intelligence Bulls/Bears poll of market newsletter writers dropped to 42.7% from 49% the previous week sparked by the recent correction. However, bearish sentiment barely moved, going from 17.3% to 18.5%. Bearish and bullish sentiment historically need to be around parity before we can confidently call an intermediate market bottom.
In July the U. S. economic expansion which began in June 2009, will set the record at 121 months as the longest in memory (see chart), beating out the 10-year, 120-month expansion which ended in March 2009. Should we be worried? Recessions tend to start not when economies are weak but at peaks when things seem to be going great, when people become too optimistic and tend to take greater risks. Take the last great expansion throughout the 1990s propelled by computers, the internet and high-tech growth in general. That ended after the high-tech stock market bubble when overly optimistic investors propelled stocks to record highs. So what could happen this time? Could it be tariff wars? Tremendous debt at financial institutions such as is happening at Deutsch Bank? Or some other unforeseen geopolitical event? Historically, bad things tend to happen at times of extreme optimism. Put another way, sh*t happens!
The Consumer Confidence Index hit another new high this month, the highest in 19 years. While one would think this is a positive, it’s actually as scary as it gets. Why? That’s because consumers typically react to what’s in the rear-view mirror. They tend to be oblivious to what lies ahead. And this herd mentality usually gets it wrong.
To put this in historical perspective, consumers are the most bullish they’ve been about the economy in two decades, since the top of the stock market internet bubble in 2000. One year later the U.S. was in a recession and the stock market was in a serious decline. Be wary when everyone is singing the same tune.
We use investor sentiment as contrarian indicators of when the stock market is oversold and overbought because investors are historically wrong about when to buy and when to sell. The recent stock market correction has moved the indicators down from very bullish sentiment levels at market peak, but not enough into bearish territory to indicate the market has become oversold. In other words, wait before you buy.
The Investors Intelligence Bulls/bears poll of sentiment among stock market newsletter writers is a good example of what the sentiment indicators are telling us (see chart below). Writers expressing bullish sentiment have gone down from 57% to 49%. But historically from a contrarian viewpoint that’s not nearly enough of a drop to indicate stocks have become oversold. An even greater note of caution is the fact that bearish sentiment among these writers has not budged, remaining below 18%. Typically at market bottoms, such as in 2016 and 2018, bearish sentiment among these writers has climbed considerably higher at the same time bullish sentiment has dropped much lower. In other words, as the chart indicates, it is going to take a big move upward in bearish sentiment and a greater decline in bullish sentiment to establish a firm market bottom that signals it is a good time to buy stocks.