Market Sentiment Is Way Too Optimistic

There’s an interesting dichotomy which is brewing in the market which is a recipe for lower stock prices. I will review this bearish signal in this article. The dichotomy is that investors are incredibly bullish while bank lending has started to seize up. Sentiment indicators can signal short term trend corrections if they get too extreme. Banks raising their standards and lowering the amount of loans given out is a signal that the short-term credit cycle is ending. This would mean the next correction could be the start of a bear market.

It’s not surprising that the sentiment indicators are saying the market is due for a correction. The S&P 500 is within 1% of its all-time high. There hasn’t been a 1% drop or greater in one session in 81 days. The VIX has an 11 handle and has been below its long term mean for several weeks. The narrative is that a 5% correction should be bought. The market will finally fall when there aren’t enough dip buyers. After it falls, there will be accelerated selling from those weak hands who aren’t used to losing money and want to lock in their profits from the bull run.

The chart below is the Investor’s Intelligence Sentiment Survey. It shows bullish sentiment is near the highs for this bull market. The past few times this level of bullishness occurred there wasn’t a major correction, so this indicator, on its own, won’t tell you where the market is headed. However, at tops there usually is a high level of bullish sentiment.

The image below shows a longer-term chart of sentiment. It expresses my point that at market peaks there is high sentiment as evidenced by the peak in 2007. The current level of bullishness is higher than in 2007. The prior cycle had its optimism focused in real-estate instead of stocks. This time there is an everything bubble, so stocks are much more expensive.

The final sentiment indicator I have below is the most powerful. It is the Complacency/Anxiety indicator created by BCA Research. It considers investor positioning, sentiment, and risk on/risk off biases. It is at a record high, signaling the market is at a euphoric stage. I find it interesting that this indicator shows the level of euphoria before the financial crisis was higher than in the late 1990s. I would argue that sentiment was higher in the 1990s because stocks became more expensive. The 1990s bubble was in tech stocks while the 2000s bubble was in real-estate. However, I think it’s great to look at this indicator because it looks at different metrics. When many indicators which use different data arrive at the same conclusion, it sends a powerful message.

Before I look at the bank lending survey, let’s first look at the chart below. The yellow line is the five-year annualized percent change in nominal GDP. The green line shows the 5-year annualized change in consumer credit. It’s not surprising to see GDP declining because this has been the slowest recovery since 1949. What’s interesting is consumer credit growth isn’t boosting GDP growth as much as it used to. In the 1990s consumer credit growth wasn’t able to help GDP as much as prior cycles. In this cycle, consumer credit growth wasn’t as fast as past cycles. At the end of the graph, you can see consumer credit growth picking up while GDP growth sags. The economy can’t handle any more debt. It needs a healthy deleveraging.

Bank loan growth is the key to the credit cycle. When banks are willing to give out loans to businesses, the economy is ably to grow above the rate of productivity growth. When banks tighten lending standards, growth declines below productivity. As you can see from the chart below, the high yield spread shows the market is in risk on mode even though C&I loan growth is in the negatives. This must correct itself soon. Either the lending environment will become less stringent or the economy will fall into a recession and the high yield spread will increase. To be clear, the high yield spread shows the difference between investment grade and junk bonds. When the difference is low, investors aren’t asking for much more returns when they take the risk of buying junk debt.

According to the Fed’s Senior Loan Officer Survey, there was an 8.3% net tightening of credit standards for credit cards and a 11.6% net tightening for auto loans. This coincides with the chart I put in a previous article which showed subprime defaults on auto loans increasing. Banks always want to give out loans, but they pull back when default rates increase because lending becomes less profitable. Commercial real estate is also experiencing weakness. As you can see below, construction and land development, multifamily, and nonfarm residential loans are all seeing a double digit net percentage of tightening standards.

As a result of these tightening lending standards, demand for commercial loans for construction and land development and multifamily are declining. Both charts are pointing towards a recession in the first half of the year. I think the economy was saved from heading into a recession last February when all the central banks got together and coordinated the expansion of their balance sheets. I think they delayed the inevitable. The question is how long their action can stave off the credit cycle rolling over.

Conclusion

            Market sentiment is showing signs of extreme bullishness. According to the BCA Research Complacency/Anxiety index, investors are the most complacent ever. This makes for a toxic combination because the commercial real estate credit cycle is tightening again. The central banks bought assets to stave off a recession last year. If the sentiment reverses causing the stock market to fall and inflation simultaneously remains high, the central banks may not be able to prevent the credit cycle from tightening and causing a recession. I don’t think the Fed should be afraid of recessions because deleveraging helps cleanse the system from excesses. However, the Fed has decided it wants to eliminate recessions and market selloffs which will only make the next crash bigger when it finally happens.