Measuring investor sentiment is the closest thing to a “free lunch” in the investing world. Knowing that the investing public cannot buy or sell forever means that, at some point, they’ll stop and prices will react accordingly. Measuring investor sentiment aims to identify these points in time. Fortunately, there are a variety of different ways to gauge sentiment and to identify extremes in investor behavior. These extremes typically indicate turning points in a market or at least peaks in momentum.
Currently, the Trump rally is sparking some excitement with investors, both retail and institutional. The S&P500 rose nearly 10% since the election and CNBC is actively making sure the whole world knows that the Dow Jones inches closer to 20,000. This type of cheerleading should normally be a red flag to viewers, particularly when more traditional indicators show elevated levels of optimism as well.
Investor sentiment typically follows prices lower or higher, and this current rally has been no exception. Although investor sentiment is not at an extreme level (yet), it’s elevated and rising. The above chart shows one of our sentiment indicators over the past several years. This data set shows optimism bubbling higher, and aside from a brief point in August, the current reading sits at the highest level since early 2015. If U.S. equities grind higher through the New Year, sentiment levels may end up in extreme territory. However, investors should be wondering if it will even matter since major fiscal policy changes are underway.
Can equities rally through a period of excessively high investor sentiment? It has certainly happened before. Prices continued higher through Q1 2013, when investor sentiment stood at similarly elevated levels and prices kept pushing higher for another two years without more than a 7% correction (18 months without even a 5% correction). At that time QE3 provided the driving force behind equity prices so that an interim spike in investor sentiment caused only a 1%-2% pullback. We think Trump may be a similar driving force.
Is the Trump victory coupled with his well-communicated fiscal plans enough to drive a similar type situation? We think it’s possible. Investors have been conditioned (and rewarded) to focus primarily on monetary policy throughout the past decade. During this time, the aggressive nature of the Fed simply outweighed anything else coming out of Washington D.C. Welcome back to an era where fiscal policy matters.
Fiscal policy does matter; in fact it is huge variable. Wall Street just forgot about it over the past decade with the Obama administration and the Federal Reserve trying to navigate the Great Recession. Now, Trump has conveyed his intention to cut corporate taxes, roll back regulation and elevate federal spending on items like defense and infrastructure. Simply put, this expansionary fiscal policy may have a market impact similar to a round of QE. Although the Fed seems to have embarked on a trend of tightening, but it will probably prove to be too gradual to be an offset.
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