Liquidity/Sentiment Review

Its seems the general consensus is this rally has to end and that we must correct, if not crash sooner rather than later. Yet Mr. Market remains uncooperative with this widely accepted view.  His plan seems to be to take the direction that involves frustrating the greatest number of traders.

Rather than look at what people are saying, let’s see what they have been doing, via how much they deviate from typical equity exposure:

AAII Stock Allocation % Deviation from 21-yr. mean

sentiment.PNG

My partner Kevin is fond of saying “Stock price direction is a function of several factors; valuation, future expectations, sentiment and liquidity.”

That last component, liquidity, seems to be most dominant lately since buying power (or lack thereof) determines if stocks go up or down.

Typically, liquidity is strongest when expectations are the most negative and people have already dumped equities; It is weakest when expectations are most optimistic.

Why? At market tops, investors tend to be “All In” — their expectations for the future are most optimistic, and that means their liquidity is spent. By the time investors go “all in,” things are about as fundamentally bullish as they are ever going to get, and stocks are fully valued. Indeed, at these “all in” junctures, valuations are typically highly stretched, with no room for earnings misses or weak forecasts.

With investors “all in” there is no buying power left in the aggregate to push stocks higher. The opposite occurs at bottoms: Investors become so pessimistic about the future they move large amounts of cash to the sidelines. We get the added benefit at this point as valuations typically have contracted as well and are now attractively priced.

With large sums of cash moved to the sidelines, valuations attractive and selling exhausted, there is no where to go but up — even if its only for a period of weeks or months.

The chart above looks at how far above or below the 21-year average allocation of 60 % invested in stocks individual investors are presently. As seen above when stock allocations drop 15 % or greater below that 22-year mean, (red circles) which has occurred only 3 times in the last 22 years (1990, 2002 and late 2008/early2009) it has equated into significantly higher stock prices 3/6 months up to several years later.

Even given the extent of the current rally, investors remain 6% below their mean allocation to stocks, and significantly below fully invested levels of 10-15 % above the mean. Sideline liquidity remains strong, investors are still not fully invested, and dips have remained fairly contained.

Anecdotal sentiment also echoes the under-invested theory as most investors expect a correction and refuse to invest as the market melts up. Typically investors talk their positioning and under investment breeds statements of caution.


Originally published at The Big Picture and reproduced here with the author’s permission.