Investor Sentiment Indicates a Possible Market Correction

A friend forwarded me an email yesterday from K2 Advisors. I don’t know anything about K2 Advisors, except that it is based in Stamford, Connecticut and its emails are packed full of interesting insights.

For example, K2 notes that:

  • Bond yield spreads have narrowed to their lowest levels since 2007. [i.e., the buyers of corporate bonds are confident. They are demanding very little incremental yield over Treasury bonds].
  • An ISI poll shows that 93% of institutional investors think we are in a bull market.
  • According to Investors Intelligence, only 15.7% of investors are bearish – the lowest reading in 20 years.

In other words, investors are extremely confident and complacent. From a contrarian standpoint, extremes of complacency tend to precede significant market corrections.

Curiously, as K2 Advisors points out, bullish investor sentiment is hitting high levels at the very same moment that inflation is heating up noticeably and the US dollar is hitting new low levels.

“The US dollar is hitting 52-week lows,” K2 observes, “as commodities are hitting new highs and TIPs-based inflation expectations are bumping up against 10-year highs.”

What does it all mean? Maybe nothing much…at least for now. But the seeds of stock market distress are germinating.

Stocks love a weak dollar, as long as it doesn’t get too weak. Then stocks hate a weak dollar, because a very weak dollar is a sign that inflation is winning…and the rest of us are losing.

During the inflationary 1970s, the stock market was a disaster. After adjusting for the ravages of that decade’s runaway inflation, stocks produced a total return of about minus 20%.

Will past be prologue?

Without access to the “Teacher’s Edition,” we have no idea. But we have some idea that inflation is bad. And we have an accompanying idea that inflation is gathering steam. Therefore, we have a deductive idea that hard assets investments will fare better than stocks over the years ahead.

That’s our deductive idea, remember, not an etched-in-stone prediction. If it’s predictions you seek, we predict that hard assets will fare much, much better than bonds over the years ahead. In fact, we would go so far as to say that within five years, the current holders of long-dated Treasury bonds will wish they were holding barbed wire instead.

By contrast, the stock market probably won’t be an entirely awful place to hang out. Stocks hate inflation; it’s true. But some stocks benefit from inflation and others are impervious to it.

The biotech and high tech sectors come to mind. These sectors tend to operate fairly independently of big picture macroeconomic trends. Instead, they respond to company-specific successes or failures – in particular, the company-specific successes or failures of embracing “transformational technologies.”

Many of these transformational technologies are what Patrick Cox, editor of the Breakthrough Technology Alert, calls “disruptive technologies.” They disrupt the status quo. They change important aspects of societal behavior. In the process, such technologies can doom previously dominant companies, while also elevating micro-cap stocks to mega-cap success stories.

Patrick is a master at identifying the transformational technologies that produce major winners and losers. In his essay “SMS: Nvst B4 It’s 2 L8” in yesterday’s edition of The Daily Reckoning, for example, Patrick explained how the technology behind text messaging is disrupting numerous aspects of communication technology – creating some surprising winners and losers in the process.

Disruptive technologies do not merely transform aspects of human behavior: they sometimes transform entire investment portfolios. Read the second part of Patrick’s essay, “Open Source Finally Wins.”

Eric Fry
for The Daily Reckoning