A bull market is always born on pessimism

“Bull markets are born on pessimism, grown on skepticism, mature on optimism, and die on euphoria.” So says the legendary investor, John Templeton. In this post, let's talk about sentiment.

Stock markets have been rising for more than six months since last fall's lows. In Europe, several stock market indices, including Germany's DAX index, are hitting all-time highs. At the same time, investors are cautious, like a bear shot in the back.

This graph shows the result of a recent Bank of America global portfolio manager survey on how many portfolio managers are overweight in bonds relative to equities. Bonds are overweight if you believe in a recession and falling interest rates. Stocks are overweight if you believe in growth. And many don't seem to believe in it now. The overweight in bonds is starting to approach the pessimistic levels of 2009.

 
Similarly, the cash level at 5.5% is high. Portfolio managers move billions of dollars in equities. If they overweight cash now, you would think that the biggest selling pressure would already be behind them, because they already have plenty of cash. On the other hand, if the market performs better than expected, they will be tempted to get back on board at any cost.

 
This curve shows in which percentile portfolio managers' economic growth expectations, cash weight and equity weight move historically. The current situation is the bleakest of the 21st century in this respect, and in many cases such places have been good or at least reasonable places to buy stocks.

On a sectoral basis, one could say that the financial sector is being despised. Portfolio managers underweight banks by as much as they did in spring 2020. Of course, they were right to underweight banks in the survey even before the 2008 financial crisis, so these surveys shouldn’t be taken as pure contra-indicators. As a rule, portfolio managers lose to their benchmark indices, but if by contra-investing them you could make systemic excess returns, the efficient market would quickly eat up this possibility. Therefore, these surveys should be taken as an indication of the prevailing sentiment.

Portfolio managers are not alone with their fears. In JP Morgan's investor survey, few see the S&P 500 index going higher at the end of the year. In contrast, two thirds of respondents believe that the index will fall to 3,500 points or below. I'm not quite sure about the target group for this survey, but I think it's retail investors. 

The survey is not floating in a vacuum, as the AAII's sentiment survey of retail investors has also been quite bearish, as you can see from this busy graph. The survey is conducted on a weekly basis by asking investors which direction they think the market is going. I added a 52-week moving average to that to make the bearishness stand out better. Measured in this way, investors are as pessimistic as they were at the bottom of the financial crisis. In turn, the red line is the average over the 35-year history of the survey.

 
The stock market is a nasty place in the sense that the market rarely delivers what everyone already expects. If enough investors are expecting a fall, they are already prepared for it and the fall is in a way reflected in the share price. The end result should therefore be even more negative than currently expected. After all, economists are expecting a recession for the rest of the year and analysts are forecasting a fall in earnings, which has already begun. If things turn out better than expected, the stock market will be boosted by this negativity.

At least for me, in a market like this, climbing up the so-called wall of worry, it feels safe to sit on stocks. The scariest year was 2021, when there was general euphoria. Back then, equities had the continuation of paradise priced in. Thus, the market was very weak to take any kind of adversity. Now, expectations are much more realistic, and investors are more clear-headed than then. Sentiment is not a very scientific way of looking at the market, but if you are bearish on the stock market, you should be aware that almost everyone else is still too. Such an environment tends to feed upward pressure.

Thank you for reading the post! Do what you will with this information and remember to make good stock picks!