Investor Optimism Is at Extreme Levels Heading into 2017

Investor Optimism Is at Extreme Levels Heading into 2017


The Dow Jones Industrial Average remains unable to cross the 20,000 threshold despite 10 days of trying. Momentum has clearly been lost. Yet based on survey and technical data, investors have reached full-on, foaming-at-the-mouth levels of bullishness. 

While I still expect a short-lived excursion above 20,000 before the end of the year, early 2017 could prove to be a rude awakening for those overconfident investors. When so many are so hopeful, things rarely work out as expected. 

Related: Why the Dow Is Struggling to Break Through 20,000

Amid all the enthusiasm, one important group of people remain steadfastly cautious: Business executives. 

Consider the chart below, which shows spending on new equipment plunging at a rate not seen since the recession, as factory equipment is increasingly idled. This is not the stuff of higher profitability and earnings, as unused equipment is a drag on margins and declining new orders weigh on revenue. 

Other economic woes you probably haven't heard about: Housing has plateaued as mortgage rates have surged following Trump's victory; exports are weak; higher borrowing costs are weighing on auto sales; and corporate insiders — especially in the industrial and financial sectors, where stocks have been soaring — have been aggressively selling shares, according to InsiderScore data. 

Related: 9 Companies That May Not Make It Through 2017

Contrast this to the widespread enthusiasm everywhere else. 

Jason Goepfert at SentimenTrader notes that his "Dumb Money" indicator, based on things like small-trader futures positioning, among other indicators, exceeded 80 percent two weeks ago. Yet stocks have continued to rise. In his words, that level of buying pressure after a reading of extreme optimism "has occurred a handful of times, and it has usually led to losses as the late buyers became exhausted." 

U.S. consumer sentiment has hit levels of hopefulness not seen since 2001, according to the latest Conference Board survey. Their expectations for stock market gains have hit their highest level since February 2007 according to Goepfert. 

It's not just small investors. The professionals are bullish, too. Barron's year-ahead session with 10 Wall Street strategists showed all 10 see the market going higher, compared with just four back in September. That’s despite valuations that, even with very aggressive earnings growth expectations, are two standard deviations above normal levels, according to Gluskin Sheff economist David Rosenberg.

Related: 10 Ways the Energy Markets Could Surprise Us in 2017

Measures of equity hedging — protecting against a surprise decline — have dropped to the lowest levels in nearly three years. These include prudent risk management strategies like raising cash, buying an inverse ETF or mutual fund, buying put options or buying credit default swaps.

Seasonality suggests traders should use the remaining "Santa Claus Rally" dynamic through the beginning of 2017 to sell, as the end of January has tended to be rather weak in recent years. Since 2009, stocks have only risen in January three times, and each of the last three years featured a January selloff.

What could motivate another January decline in 2017? Credit Suisse worries pensions funds could be the spark that catalyzes a selloff. The post-election rally in stocks has been accompanied by a dramatic plunge in bond prices. For pension funds with strict asset allocation targets, the end of the fourth quarter and the end of 2016 will likely motivate the need to sell recent winners and buy recent losers to bring allocations back into alignment. 

Credit Suisse analyst Victor Lin warned recently that the "estimated rotation out of domestic U.S. equities would be one of the largest on record" given the large outperformance compared with other assets classes on a monthly and quarterly basis. Lin estimated that rebalancing pension funds would need to sell at least $38 billion worth of equities and buy $22 billion worth of U.S. bonds. That could make for some big market swings.