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Sentiment Creeping Higher

(February 10, 2012)

Dear Subscribers and Readers,

Make no mistake: We remain bullish on US financial stocks, due to near historical low valuations, the resilience of the US economy, a hugely oversold US housing market, along with an ongoing easing policy adopted by most of the world's central banks. Speaking of which (and not surprisingly), the Bank of England implemented another QE mandate yesterday—taking up its QE asset purchase facility from a limit of 275 billion to 325 billion pounds. On average, with the exception of Christmas and New Year's Holidays, the Bank of England has purchased about 5 billion pounds of Gilts on a weekly basis, almost as much as its initial pace from March to early July 2009 (see below chart).  Currently, the size of its balance sheet is 274 billion pounds ($433 billion). The Bank of England expects its latest round of purchases to be completed by the end of April. I expect the Bank of England to then pause—but then announce another 50 billion pound package later this year given the ongoing liquidity issues in the Euro Zone.

Meanwhile, one of our U.S. stock market liquidity indicators—the amount of cash sitting on the sidelines—has continued to decline. This is measured by the ratio of the amount of money market funds plus checkable deposits divided by the S&P 500's market cap; see our July 26, 2009 commentary for more background.  Since its February 2009 peak, it has declined very quickly, but has bounced slightly over the last nine months.  As of the close yesterday, however, it is only 1.42% above its cyclical bull market low (set at the end of April 2011), as shown in the following chart:

As discussed in the above chart, the ratio of investable cash (retail money market funds + institutional money market funds + total checkable deposits outstanding) to the S&P 500 market capitalization has declined consistently from February 2009 to April 2011.  The ratio bottomed at 28.00% at the end of April 2011, and has since bounced slightly to 29.42%.  This liquidity reading remains low, and along with our overbought sentiment indicators, suggests the market is getting very vulnerable to a correction.

The overbought condition in our sentiment indicators is reaffirmed by another sentiment indicator (which we first covered in August 2010)—the percentage of overall equity exposure for 40 NAAIM (National Association of Active Investment Managers) member firms who are active money managers.  Since this survey contains leveraged and long-short strategies, responses can vary widely.  The results are averaged to come up with the results (inception of the poll is 2006).  On Wednesday, the NAAIM reading jumped to 72.66, its most overbought reading since May last year, as shown in the following chart (courtesy of Decisionpoint.com):

As shown on the above chart, the U.S. stock market has either corrected significantly or endured a tough time whenever NAAIM net equity exposure pierced the 80% level over the last three years.  Conversely, the best time to buy U.S. equities is when NAAIM net equity exposure declined to 20% or below.  While a 72.66 reading doesn't signal an imminent correction, it certainly bears watching. That said, we remain bullish on the U.S. stock market over the next 4 to 6 months.

Signing off,

Henry To, CFA, CAIA

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