Market Extra: Stock optimism swells as S&P 500 hits most overbought level in 22 years

Following a year in which the U.S. stock market hit a record number of records and seen basically nothing in the way of pullbacks or volatility, investors have gone all-in on stocks.

Exchange-traded funds, perhaps the most popular way to get exposure to broad parts of the market, have seen record-breaking inflows over the year, with both domestic and foreign-based stock funds seeing heavy interest and no major category seeing outflows. Both retail and institutional investors have gotten in on the action and are positioning in a way that suggests both see further gains ahead. The S&P 500 SPX, -0.01% has rallied about 20% over 2017, on track for its best year since 2013.

According to Torsten Sløk, Deutsche Bank’s chief international economist, “U.S. retail investors say that today is the best time ever to invest in the market,” based on data from the University of Michigan consumer sentiment report, which asks about the probability of an increase in stock prices over the coming year. Younger investors in particular are warming up to equities, according to E*Trade.

The latest AAII investor sentiment survey indicates that 50.5% of polled investors are bullish on the market, meaning they expect prices will be higher in six months. That’s the highest level in nearly two years, and significantly above the 38.5% historical average. The number of bullish investors has gone up by 5.5 percentage points in the last week alone, while the percentage of bearish investors has dropped to 25.6%, down 2.5 percentage points over the last week.

Optimism has gotten so high that cash balances for Charles Schwab clients reached their lowest level on record in the third quarter, according to Morgan Stanley, which wrote that retail investors “can’t stay away.” The investment bank noted a similar trend in institutional investors, who it wrote were “loading the boat on risk,” with “long/short net and gross leverage as high as we have ever seen it.”

There have been fundamental reasons for this optimism, including a strong labor market and improving economic data. Furthermore, the recently passed tax bill will cut corporate taxes, which should boost corporate profits — which have already been enjoying their fastest year of growth since 2011.

Learn more: Corporate earnings and revenue were strong in 2017, but that’s not the whole story

However, the incessant buying has pushed valuations to levels that are not only stretched, but stretched to a historic extent. As was recently noted by LPL Financial, the relative strength index, an indicator of technical momentum, is at its highest level since 1995, which indicates the S&P 500 is at its most overbought level in 22 years.

“This has many market participants suggesting equity markets are ripe for a substantial pullback at any time,” wrote John Lynch, the firm’s chief investment strategist.

Being overbought may sound like a negative for markets, but the “historically super overbought level” that markets have recently been trading at hasn’t always been followed by declines in the past.

“Somewhat surprisingly, the future returns are actually stronger after such periods of overbought natures,” Lynch wrote. “For instance, a year after being overbought, the S&P 500 is up 12.8% on average versus the average gain of 8.8% and higher 12 out of 13 times, which suggests there may be a good chance for solid market returns next year.”

Beyond those historical trends, investors are torn over the prospects for 2018 and beyond, though most analysts are expecting tepid returns. Equity strategists surveyed by MarketWatch expect the S&P to end next year at 2,819, which represents upside of about 5% from current levels. Meanwhile, in contrast to the bullishness expressed by the AAII poll, a survey from the Boston Consulting Group pointed to growing caution.

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“Overall, 68% of respondents think the market is overvalued — by an ­average of 15 percentage points,” read BCG’s analysis of its survey. It noted that the percentage of bearish respondents was “more than twice the 29% of investors in last year’s survey who thought the market was overvalued.”

Only 16% said it was undervalued. Furthermore, investors on average are expecting total shareholder returns (TSR) of 5.5% over the coming three years, “the lowest percentage we have recorded since we began asking about TSR expectations in 2010, and close to half the long-term average TSR of 10% that companies have achieved over the past 90 years.”

More than half the investors in BCG’s survey — 53% — say the next economic recession will occur over the next two years; only 18% say it is more than three years out.

Deutsche Bank’s Sløk said there was “an elevated probability that the U.S. economy will enter a recession in 2020,” citing the risk of slowing revenue and earnings growth, as well as Federal Reserve policy. Morgan Stanley, also citing “decelerating growth,” recently wrote that there were “rising recession probabilities in 2019.”

James Swanson, chief investment strategist at MFS Investment Management, recently developed a “recession checklist” of nine factors that point to a coming contraction in growth. Of the nine, three were deemed “worrisome,” while another five were considered potentially worrisome. Only one of the nine — related to inventory levels — was deemed not a worry.

“While we don’t appear to be in near-term danger of recession, there are growing indications that we’re late in the business cycle,” Swanson wrote. “Markets tend to become most enthusiastic late in the cycle, and we’re seeing clear signs of that today.”

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