Virus: Could it be the Catalyst to Change Sentiment?

Key Points

  • Heed Keynes’ message about markets staying irrational...
  • Being a contrarian just to be a contrarian is rarely profitable; but investors need to be mindful of the message that sentiment indicators are nearly-universally sending.
  • There are lots of extremes; but perhaps comparisons to circa 2000 have been overdone.

Before we get to the matter at hand, we are all mourning the loss of the great Kobe Bryant and his beautiful daughter Gianna. What a heartbreaking period for his family and his fans. His legacy across the world of sports will live on for generations to come.

I’ve often remarked that it’s rarely wise to be a contrarian just for the sake of being a contrarian—especially where the stock market is concerned. The gains over the past year have been remarkable; not just for their magnitude, but also for their consistency. But the power of the momentum move brought with it very extended investor sentiment conditions. Sentiment can move into the extreme optimism zone and stay there; while being right for an extended period. It’s difficult to pinpoint the inflection point in advance. As John Maynard Keynes famously said, “The market can stay irrational longer than you can stay solvent.” What extreme optimism does though is establish a greater amount of vulnerability to the extent there’s the arrival of a negative catalyst.

Before putting more meat on the bones of sentiment in this longer-than usual missive; a shout-out is warranted to the source for much of what follows. I have been an avid user of the work of SentimenTrader for many years courtesy of their robust database and historical studies; but also their unique look into the behavior side of investor sentiment (in contrast to the many attitudinal measures I also track). For sentiment tea leaf readers among our readers, they offer a free daily newsletter, which I highly recommend.

Friday: blip or sign?

Friday’s stock market weakness was neither sufficient in scale or scope to suggest a sentiment-exacerbated pullback is upon us; but if the weakness persists, we may point to the coronavirus as the negative catalyst. That is clearly the case in Monday’s pre-open session (at which point this report was submitted).

To put some color on Friday’s market behavior, the S&P 500 gapped up early in the day; opening above its highest close over the prior five days, but closing below its lowest close over the prior five days. According to SentimenTrader (ST), this type of reversal pattern historically led to short-term weakness over the next week or so.

The S&P 500 was down more than 1% near the close, but recovered a little in the approach to the close. While not a major loss obviously, the index had gone 73 days without a loss greater than -0.9%—ranking among the longest streaks since the S&P 500’s inception in 1928. Historically, there were mixed results in the ensuing month or two; but when ST broadened it out to -1.0% streaks, the returns were weaker, though not yet applicable obviously (although perhaps applicable after today’s close).