INSIDE THIS EDITION
Bullish and Bearish Signals and What They Tell Investors Today
Investors have experienced a remarkably active five months to start the year across equity, fixed income, and commodity markets. Inflation has proven to be less transitory than the Federal Reserve believed, resulting in a more hawkish Fed. With a rising interest rate environment now, bonds have declined in chorus with stocks that are currently experiencing their first bear market since the pandemic’s start nearly two ago. Although declines in financial asset prices don’t feel good and hurt investor sentiment, bear market episodes have historically been short-lived. And more importantly, as stock and bond prices suffer, valuations become more attractive and set the stage for better future returns and improvements in investor sentiment.
As the chart below shows, the AAII bull-bear spread ratio is depressed now. It is lower than what it was at the height of the pandemic and is approaching levels seen during the great financial crisis in 2008. Historically, as the indicator declines beyond these levels, it can be a contrarian indicator to add stock exposure. However, today while we see things approach more favorable valuation levels domestically, a further downside to stocks and elevated volatility could still lie ahead.
The short interest level for the median S&P 500 stock tells us this, at least. Short interest is another sentiment indicator some investors use to determine bearishness or bullishness in markets. When short interest is declining, it signals that investors are becoming more bullish, and when it is rising, it signals that investors are becoming more bearish. Today, we have short-interest levels for the typical stock at 1.5%, the same level we saw during the dot-com crash in the early 2000s. It has declined since the pandemic, albeit less sharply more recently.
And that may not be the only reason to be more cautious about stocks now. Inflationary periods tend to usher in difficult times for stocks, with inflation volatility historically leading to inflation-adjusted returns on equities of -7% per year, according to the Man Institute Research.
All of which is interesting considering that buyback activity and margin debt trends tracked by FINRA are flashing more bullish signals. The charts below show buybacks by corporate clients at Bank of America Securities and the FINRA margin debt 12-month z-score.
Due to the familiarity with buybacks, we will focus on what the margin debt z-scores might be telling us in the chart below. The z-score for margin debt has dropped to -1.91 through April, approaching the -2.0 level seen in March 2020, when the S&P 500 hit its low. When the z-score gets to or below -2.0, it can be a bullish signal for US stocks, as it was during many of the most recent selloff.
The path forward is highly uncertain. But, perhaps instead of using the signals to forecast the day-to-day moves of the broad market, diverging signals should serve as a reminder that there are always reasons to be bullish and always reasons to be bearish. And that it is up to investors to find a process that allows us to sleep well at night, manage risk, diversify appropriately, and, more importantly, have a long-term mentality when it comes to investments, as these factors will ensure that we have a plan, stick to it, and ultimately get a good result.
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Avidian Wealth Solutions may discuss and display, charts, graphs, and formulas that are not intended to be used by themselves to determine which securities to buy or sell, or when to buy or sell them. Such charts and graphs offer limited information and should not be used on their own to make investment decisions.