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Old-School Contrarians Say Stock Sentiment Getting Out of Hand

Old-School Contrarians Say Stock Sentiment Getting Out of Hand

In a market that hasn’t had a 5% drop in nine months, where records are falling every fourth day and where corporate earnings just doubled, it has occasionally seemed like the good news will never end. That’s how investors are starting to behave, and it’s bothering researchers.

Rather than temper expectations after a rousing rally, bulls are getting more bullish. Almost two-thirds of clients in a JPMorgan Chase & Co. survey said they plan to add to stock holdings in the coming weeks. Among the minority of respondents who say they’re worried about the coronavirus delta variant, nearly all said they anticipate its impact being temporary.

All this giddy sentiment has pushed a Bank of America gauge that plots levels of strategist optimism to a post-crisis high, which the bank says has left it close to triggering a “contrarian sell signal.” People are going all-in at a particularly risky time -- the period after this cycle’s peak of earnings growth, which has ushered in subpar returns in the past.

“The exuberance remains pervasive,” said Michael O’Rourke, chief market strategist at JonesTrading. “The triple peaks theory -- of peak earnings, peak economic growth and peak stimulus -- is legitimate, and investors should be cautious. Economic growth and earnings will still be positive, but there will be deceleration in that growth, which the markets will react to.”

Though stocks are in the midst of a momentous earnings season, with profits in the second quarter up 89% from a year ago, the rate of growth for firms in the S&P 500 Index is projected to slow in each of the next three quarters. The last three times that happened coming out of a recession, stocks suffered, according to RBC Capital Markets.

“Slowing EPS growth rates tend to trip up stocks temporarily,” wrote Lori Calvasina, head of U.S. equity strategy at the bank. “This makes the case for a modest pullback in the broader U.S. equity market during the back half of the year.”

Old-School Contrarians Say Stock Sentiment Getting Out of Hand

Calvasina did caution that this “does not suggest the bull market is done by any stretch.” Any weakness tends to be short-lived, with stocks usually up on in the subsequent year after such a peak, she said.

In fact, it’s a risky move to declare that the market has formed a top. While it’s a time-honored practice on Wall Street to look to overheating sentiment as such a predictor, it’s a strategy whose efficacy has dimmed in an era when retail investors have grown accustomed to buying every dip. The S&P 500, up 17% since the start of the year, in July marked its sixth straight monthly gain, the longest such streak since 2018. The gauge has gone 186 days without a 5%-or-greater pullback.

Mike Wilson, chief U.S. equity strategist at Morgan Stanley, says the market’s in the midst of a transition -- from early-cycle to mid-cycle -- which is characterized by weak breadth and outperformance by quality stocks, among other things. It would take a correction to move on to the next phase, which is why he recommends investors avoid early-cycle sectors and position more defensively. His team is overweight the health-care and staples sectors as a way to guard against near-term growth deceleration, he wrote in a note.

A Morgan Stanley model based on earnings revisions breadth is signaling a mean forward three-month return of 1.2%, though a decline to average levels suggests a possible 14% selloff. (The bank defines earnings revisions breadth as the difference between upgrades and downgrades in sell-side earnings estimates over the total number of estimate changes.)

“Peaking revisions breadth implies a poor risk reward skew near term,” Wilson wrote. “Unless revisions breadth works back toward the highs, risk reward skew for price returns looks poor over the next 3 months,” he said. Many of the drivers behind the beats in the first half of the year -- including the reopening, stimulus checks, and what he calls the “crypto wealth effect,” among other factors -- are dissipating.

Old-School Contrarians Say Stock Sentiment Getting Out of Hand

Meanwhile, Bank of America’s Sell Side Indicator, which tracks strategists’ average recommended equity allocation, is at its closest level to the “sell” threshold since May 2007. Back then, the S&P 500 fell roughly 7% in the subsequent year, according to the firm’s strategists led by Savita Subramanian.

The indicator’s current mark -- which reflects a pause in sentiment amid mixed economic data, the spreading delta variant, anticipation of Federal Reserve tapering, and inflation -- indicates “tepid returns,” the strategists wrote. It’s forecasting 12-month returns of 7%, “a much weaker outlook” compared with an average forecast of 13% since the end of the Global Financial Crisis, they said.

Stocks could fall from here given uncertainty over growth and the rapidly proliferating delta variant, Callie Cox, senior investment strategist at Ally Invest, said on Bloomberg’s “QuickTake Stock” streaming program Monday. She recommends investors add to their defensive positioning, but, she said, “it’s so important to remember that history shows us that the market tends to go up over time.”

©2021 Bloomberg L.P.