Sentimental behaviour

Using technical signals to gauge market mood

To put it mildly, this is not an easy time to analyze equity markets. The COVID environment has compromised many of the ways that investors traditionally value stocks, and with so many unknowns still in play – how economies can safely reopen, when a vaccine might be developed, how quickly consumers and businesses will get back to “normal” – it’s understandable why some might feel like they’re flying practically blind.

So, how can investors make better sense of markets when so much remains uncertain?

One approach is to supplement traditional fundamentals with technical analysis, which looks at patterns in market data to identify potential trends. Another related approach is sentiment analysis, which can suggest where markets are headed by looking at the behaviours of different market participants. We have been employing both of these forms of analysis on a strategic and tactical level during the crisis, and in our view they performed well in the absence of meaningful fundamental data. In each category – technical and sentiment – we have been focusing on four specific factors that we believe are relevant to current and future conditions.

Among the technical instruments we watch every day, the most obvious is the S&P 500 Composite Index, which broke through 3,232 – an important inflection point – at the end of July on its way above 3,300. If the index can hold there in a sustained way, that would suggest a base of support is forming around 3,300 – a constructive signal for the S&P 500 to break through to 3,457. If, however, it can’t hold above 3,300 and drops down to the low 3,200s – around its former support base – then that might indicate it’s a good time to put more money to work in equities.

Still on the S&P 500, we follow the CBOE Market Volatility Index – the so-called VIX, which measures volatility expectations based on the options market. Not surprisingly, the VIX spiked at the height of the panic and has levelled off since then, though volatility remains high by historical standards. The VIX is above 22 this month, compared with sub-15 pre-pandemic, but it’s come down dramatically in the past few weeks. A sustained tick below 20 in the coming months would be a bullish signal for stocks, since a sub-20 VIX has historically been supportive of equities. It would also suggest that the market is growing more confident in its expectations for the course of the pandemic and its resolution.

Another instrument we watch closely is the price of gold. It broke through the important US$2,000 resistance level in early August, and that has gold bugs pretty excited. On the downside, there seems to be a support level at US$1,850, which (as above for the S&P 500) might provide an opportunity if gold plumbs those depths again.

For equities, a soaring gold price is theoretically a bearish indicator, but the more important relationship is to the U.S. dollar, which is another instrument we pay close attention to. Over the past few weeks, gold has surged as the U.S. Dollar Index, which measures the greenback against a basket of currencies, has fallen hard. As recently as mid-May, the USD index (DXY) was hovering above 100, but in recent weeks it has fallen below 93. We see the next support level for the dollar at 90, and if it breaks below that, it’s a bullish indicator for gold and a very bullish indicator for emerging markets, especially those with substantial USD-denominated debt.

Compared with the hard data of technical indicators, divining market sentiment can be much more complex. To get a handle on where sentiment is going, we focus on trading activity among four important investor segments.

* The first is hedge fund managers. For many weeks following the worst of the COVID panic, hedge funds were very bearish, but they have more recently flipped to bullish positions.

* The second group is long-only asset managers, who are (and have been) more bearish in their positions, which is consistent with their generally more conservative approach.

* The third group is so-called “advised” retail investors – those who work with financial advisors. We see them as neutral-to-bullish in the current environment, and our expectation is that they will become more constructive on the markets if the rally continues to have legs.

* The fourth group of investors we monitor for sentiment is self-directed retail investors, and they merit special focus. As a group, they have been super-bullish during the rally, and they are driving the markets on a daily basis. Consider that last year, self-directed retail investors accounted for only 8% of daily volume in the U.S., according to market maker Virtu Financial. By the end of this June, they accounted for 26% of daily volume. So they have been very active and very bullish. From a sentiment point of view, that is both a good thing and a potentially bad thing. It’s good to have more market participants, and obviously (just about) everybody likes to see stocks rise. However, retail investors can be subject to quick turns in sentiment and to panic – bad news, even if its impact is only short-term, could lead to a mass exodus from markets.

On the whole, however, these technical indicators and sentiment measures suggest that the COVID rally still has room to run and that optimism about the market is growing, especially for those with a 6- to 12-month market view. We shall see, of course, whether that optimism is justified, and how well non-valuation models continue to predict market movements. For now, that may be the best investors have to work with.

John Christofilos is Senior Vice-President, Chief Trading Officer and Investment Management Operations Strategy, at AGF Investments Inc.

He is a regular contributor to AGF Perspectives. To learn more about our fundamental capabilities, please click here.

Notes and Disclaimer

The commentaries contained herein are provided as a general source of information based on information available as of August 10, 2020 and should not be considered as investment advice or an offer or solicitations to buy and/or sell securities. Every effort has been made to ensure accuracy in these commentaries at the time of publication, however, accuracy cannot be guaranteed. Investors are expected to obtain professional investment advice.

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