The stock market is akin to a manic depressive, according to legendary investor Warren Buffett.
He was referring to the market’s tendency to swing from exuberance to deep negativity, and his comparison seems pertinent in the context of recent months.
Up to the end of January, global equity markets staged a V-shaped recovery, with the MSCI AC World index returning 4.5% following the notable sell off during the fourth quarter of 2018.
Over this period we have seen sentiment - as measured by the American Association of Individual Investors (AAII), a widely-followed indicator of individual investors’ mood - move from an extremely bearish reading in December back to a three month optimistic high by the end of January.
The reversal was driven by solid US economic data, better than expected corporate earnings, a dovish shift in the Federal Reserve’s forward guidance and signs that a potential fiscal stimulus in China might avoid a meaningful economic slowdown.
How positive are US private investors feeling?
(AAII Net position of positive/negative sentiment)
Source: AAII, Bloomberg
As a result of the recovery in share prices the dislocation which opened up between equity market valuations and economic fundamentals has now disappeared.
The valuations of a majority of global equity indices are now back to either in line or slightly above 15 year average levels on a price to earnings basis. Whilst we continue to see some attractive value opportunities, broadly we expect equity market returns for the rest of the year to be more modest.
Despite the more supportive environment for shares and other risk assets, there are a number of key political and macro economic risks which could test recently improved investor sentiment leading to bouts of volatility. Notable examples are upcoming deadlines for Brexit and a US China trade deal.
“Resistance level” may limit future market gains
There seems to be a relatively significant “resistance level” forming for the S&P 500 index around its 200 day moving average price. At the time of writing the market is already at or close to that level – around 2,750.
A “resistance level” is determined by trading patterns and marks a specific price or point in the index where selling will kick in and prevent the market from rising higher. Only a strong surge of optimism is likely to break through this barrier.
Without any such surge, or if we see sentiment weaken, it may be the case that continued selling pressure will see the US equity market fail to make much progress beyond this level.
While investor sentiment can help explain shorter-term market moves, our equity strategy remains grounded by both valuations and our fundamental outlook.
While global economic growth is slowing, we are not expecting a recession in the next 12 months. We were comfortable maintaining our equity allocation throughout the fourth quarter, and this has proved to be beneficial to returns at the start of the year.
We remain happy with the existing equity weighting across portfolios.