Red Flag Day: Bond Yield Spike Denting Euphoric Sentiment

Key Points

  • Investor sentiment measures recently hit historic extremes of optimism and speculative excess; but until recently, strong market breadth served as an offset.

  • The fundamental catalyst for what has been a volatile “reset” of some valuation extremes was the recent spike in bond yields.

  • Some of the high-flying “low quality” baskets of speculators’ favorites this year have recently taken it on the chin.

“Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.”

-Investor and mutual fund manager Sir John Templeton

As illustrated so well in Templeton’s most famous quote, investor sentiment, at extremes, often corresponds to contrarian inflection points in the stock market. However, there is nothing precise, historically, in terms of timing. In general, periods of despair—as measured by both attitudinal and behavioral measures of sentiment—and typically occurring well into corrections and/or bear markets—tend to have shorter time spans. As such, they historically have tended to be more effective in signaling stock market inflection points.

Periods of optimism and/or euphoria often have persisted over longer time spans—a case in point would be the late 1990s. As many might recall, former Federal Reserve Chair Alan Greenspan uttered his now-famous “irrational exuberance” concerns in late-1996—more than three years before the market’s ultimate peak in March 2000.

Market peaks that are accompanied by euphoric sentiment extremes sometimes have a specific catalyst, but not always. Put another way, heightened optimism/euphoria suggests heightened risk of a contrarian market move. Historically, there have been catalyst-driven contrarian shifts in the market’s direction; but sometimes the market simply begins to fall under the weight of excess optimism or stretched valuations, without a specific catalyst. The peak of the dot-com bubble in March 2000 was an example of the latter (no specific catalyst), while the peak in stocks in February 2020 was triggered by the mother of all catalysts—the COVID-19 pandemic.