If you're playing a poker game and you look around the table and can't tell who the sucker is, it's you.
– Paul Newman
In poker, the phrase “all-in” describes the action of wagering a player's entire stake on a single hand, pushing all of his or her chips into the center of the table. Amateur players love the prospect of quickly building their stack of chips and are more than happy to risk everything to do so, even when the odds are against them. Professional players are more hesitant to go all-in and only do so when the odds are tilted heavily in their favor.
In today’s equity markets, most investors are currently all-in on US equities. This is, of course, coming after what can only be described as an outlier year. The S&P 500
(INDEXSP:.INX) just had its best year since 1997 (up over 30%) and one of the smoothest advances in history (never touching its 200-day moving average the entire year). With such a strong, steady advance, complacency is inevitable, and that is indeed what we are seeing today.
Four sentiment indicators are now in extreme territory rarely seen in combination throughout history:
1. Investors Intelligence Sentiment
Advisory sentiment, as measured weekly by Investors Intelligence, is currently at its highest level since February 1987 with bulls at 59.6% and bears at 14.1%. The spread between bulls and bears of 45.5% is higher than 96% of historical data points.
2. AAII Sentiment
Individual investor sentiment, as measured weekly through the AAII survey, is at its highest level since January 2011 with bulls at 55.1% and bears at 18.5%. The spread between bulls and bears of 36.6% is higher than 93% of historical data points.
3. NAAIM Sentiment
Active manager sentiment, as measured weekly through the NAAIM survey, is showing one of the highest readings in its history. At nearly 100%, the current reading is higher than 98% of historical data points and is reflecting a nearly fully invested position (a reading of 100% reflects a 100% long position) among active managers.
4 CBOE Equity Put/Call Ratio
Options market sentiment, as measured daily through the ratio of puts (bearish bets) to calls (bullish bets), is currently showing one of the lowest levels in history. A 10-day moving average of the equity put/call ratio is at its lowest level of the year, lower than 97% of historical occurrences. Traders and investors have had little incentive to buy puts to hedge their gains as declines in 2013 have been few and far between (only one pullback greater than 5% in the S&P 500).
There are many parallels between poker and trading, but the most important is definitely the concept of risk/reward. You are supposed to bet small, or fold, when the risk/reward is poor and large when the risk/reward is favorable. Only when the risk/reward is overwhelmingly skewed in your favor should you consider going all-in.
Traders and investors in US equities are currently working under the assumption that the odds are in their favor, as the sentiment indicators above indicate that they are most definitely all-in. Unfortunately, their assumption is based on recency bias (the tendency for investors to project their most recent experience into the future) and not actual data. The elevated sentiment data currently suggests that we are more likely to experience lower returns in the future than in the recent past (see table 1 below). As the table indicates, when the spread between bulls and bears in the Investors Intelligence survey has been this high in the past, below-average returns have followed. Additionally, as the second table below indicates, when the S&P 500 has been up more than 15% in a year, it has (on average) posted below-average returns in the following year.
Table 1: Investors Intelligence Levels and Subsequent S&P 500 Returns
Table 2: S&P 500 Returns, Current Year Vs. Next Year
This data doesn’t mean that we can’t have another positive year in US equities, just that investors should not be going all-in with the assumption that any positive year will mirror 2013. More importantly, investors should not be abandoning all asset allocation and risk management in chasing the recent performance in US equities. If 2013 was the year of divergence between US equities and almost everything else, 2014 is more likely to be the year of convergence, especially given current sentiment levels. If the risk-on trade remains favorable as it is today, this convergence is likely to be between emerging markets and US equities, with the much-maligned Emerging Markets Index
(NYSEARCA:EEM) having the potential for significant outperformance.
No positions in stocks mentioned.
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