What Really Drives Market Sentiment?

I mentioned last week that bullish sentiment was getting a bit frothy. After a few weeks of record highs, expectations that stock prices will continue rising had surged.

Not quite an extrapolation of recent trends into infinity, but getting there.

This morning, I wanted to address the flip side of that — Bearish sentiment (expectations that stock prices will fall in the near future). This Pessimism remains above historical average.

As I noted all the way back in 2009, this is the most hated rally in Wall Street history. Many participants are unable to pry their eyes from the wreckage in the rear view mirror. This impacts their psychology, investment posture, and allocations.

Consider the initial over-reaction to Cyprus. The swiftness in which the bearish commentariat erupted over the weekend was a wonder to behold. It also was far more revealing of the bears own confirmation bias than anything it said about the circumstances in Cyprus itself.

Some have made a big deal of the January inflows into equities — the biggest in years — as a sign of the top. Perhaps a little context might help put this into perspective: The $20 billion dollars added to U.S. stock funds in 2013 pales when compared to the over $600 billion in outflows from equity funds over six years though 2012. It is also less than half of $44 billion that flows to fixed-income managers in 2013 (ICI).

Thus, we have a market which remains disliked, under-owned by investors, not unreasonably priced, with few alternatives to equities. (Does that sound like the recipe for a market crash to you?)

Let me be clear about one thing: I am not implying in any way an organic rally. The normal 20-30% pullback we might have seen as the economy slowed and earnings weaken has been thwarted by Swingin’ Uncle Ben & His No Limit Orchestra. Any concerns I may have had about a pre-recession 30% correction was shelved once QE4 became imminent. The Fed is erring on the side of doing too much this go round, versus their 1930s error of doing too little.

Perhaps this thwarting of normal cycles accounts for some of the angst we see amongst the bearish contingency. Maybe they will eventually be proven right after missing a 146% move off of the March 2009 lows — a hollow victory at best.

In the meantime, it is helpful to understand what it is that is driving sentiment, in the context of the larger picture.

Note: With this post, I am breaking out Psychology and Sentiment into two distinct categories.

Previously:
The Most Hated Rally in Wall Street History (October 8th, 2009)

Strategists Most Bearish on Equities since 1985 (August 1st, 2012)