After experiencing a huge decline in investor sentiment during the market swoon in October 2014, nearly everyone has become bullish again. Professional investors are now fully invested. Sentiment has topped the 2007 high, prior to the large draw down in equities.
Clearly, not only do professional investors have short memories, but as a group they’re terrible capital allocators!
In just five months, sentiment has bounced from one extreme to another. Collectively, professional investors became bearish at the exact intermediate low in the market. Looking at the chart, the sentiment was only 10%. Now everyone is bullish again with allocations at 100% in equities.
This is a reason to be cautious.
As the chart shows, when sentiment tops 73%, annualized returns are just 1%.
At these levels it becomes harder to push equities higher. Everyone is already fully invested.
As I have mentioned previously, mutual fund cash positions are at extreme lows. Growth and income funds hold just 2% cash while aggressive growth funds have only 2.8% cash on hand. So, when sentiment swings back around to a more pessimistic view, stocks will have to be sold to meet redemptions. As a result, when everyone tries to run for the fire exit at the same time, liquidity dries up.
What happens when liquidity dries up? Prices tend to overshoot to the downside, which only exacerbates the move even more and further reinforces the negative market sentiment.
Ultimately, this creates a vicious cycle.
For the last several years the pullbacks have been shallow and short-term in duration. People have been preconditioned “to buy the dips.” In my opinion, this only means that that crash, when it comes, will be much deeper and scarier than anyone now thinks.