The sentiment that matters

One of the striking features of this bull market has been the reluctance with which investors bought risky assets. Despite US equities rebounding to all-time highs by August, sentiment readings – be they surveys or more market-based measures – had stayed neutral. Not anymore.

Over the past week, after the US election and vaccine news, investors’ animal spirits seem to have emerged at last. The AAII Bull/Bear spread, one of the indicators we rate most highly, jumped to its most bullish reading in nearly three years and one of the highest since the financial crisis. Recent fund-manager surveys from Bank of America, Strategas and ISI showed a similar surge in investor optimism.

The mood swings, finally

To cap things off, the first sell-side outlooks for 2021 have also been more optimistic than both the historical average and last year’s ‘mid-single-digit upside’ consensus. The average S&P 500 target for end-2021 from Goldman Sachs, Morgan Stanley and Credit Suisse suggests 15% upside from here.

But despite the notable spike in investor bullishness, our own indicators are not sending contrarian sell signals yet. Our interpretation is that sentiment has simply become a headwind, rather than so excessively exuberant that it starts to dominate our thinking about equity risk. Even at the latest reading of 31% net bulls in the AAII survey, for example, the average return over the following 12 months has been +6.3%, not far below the average return in any 12-month window. Historically, only readings above 40% net bulls have been significant sell signals.

Somewhat bullish sentiment is one factor keeping our tactical equity allocation neutral. On a medium-term horizon, we concentrate more on the fundamental backdrop for equities, which supports a slightly positive view. Recession risks appear low and we are still early in the economic cycle, with risk-adjusted equity returns having historically been strong from this stage of recovery, while equity valuations are elevated but understandable given extremely low bond yields.