Examining stock market sentiment is an important tool to help investors assess risk. It doesn't give any indication of the future move in price, but it does give investors insight into the potential move in either direction. For example, stock market (NYSE: SPY) sentiment was very bullish early in the year.
Speculative, momentum stocks without any earnings or revenue were seeing massive gains like Virgin Space (Nasdaq: SPCE). There was an explosion of volume in short-dated call options. Greed was dominant over fear. With the coronavirus catalyst, stocks plunged, wiping out gains from the past three years.
At the lows in March, the opposite dynamic took hold. Stocks were opening limit-down for multiple days in a row. The scope of the coronavirus was unclear, including the extent of a shutdown necessary to combat it. This led to fear being the dominant emotion. Short positions increased, and long positions were liquidated which created the conditions for a powerful, counter-trend rally which has gone further than many believed.
Sentiment Today
At the March lows, sentiment hit extreme bearishness on multiple timeframes. Today, sentiment is neutral on an intermediate and longer-term timeframe, while it's reached excessively bullish levels on a shorter timeframe. This is clear with the CNN Fear/Greed Index which is in the mid-40s. At the beginning of the year, it was in the 90s. Then, it plunged to single digits by the end of March.
In the short-term, the market's thrust higher has led to the put/call ratio dropping below 1 for the last two weeks which indicates traders are buying more calls than puts. Additionally, there has been an explosion in puts that are bought with expiration dates in the next couple of weeks.
Bear Market or New Bull Market
Even if the market is in a new bull market and going to make higher highs higher lows for the rest of the year, it's unlikely that buyers of speculative, high-risk contracts will be rewarded following a 35% gain in a month and a half. More likely is a pullback to reset sentiment in the short-term to neutral or bearish levels.
This is an important juncture for markets and will determine whether this is a bear market or if it's a bull market. If it's a bear market, bullish extremes in short-term sentiment are ideal entry points to sell or initiate shorts. Both sides make compelling arguments.
Some of the arguments on the bear market side are that the market's rise and composition are different than what is typically seen in previous market bottoms; the economic damage from the coronavirus has just started and is spreading through the economy; markets were pricing in strong doses of monetary and fiscal stimulus and will now focus on the economic damage; relaxing of shutdowns could result in a "second wave" for the virus; and, the market is due for a longer, period of contraction and multiple compression following a more than decade-long bull market.
The bull market arguments are that the mega-cap, technology companies (Nasdaq: QQQ) that comprise the bulk of the indexes are insulated from the coronavirus; interest rates are at record lows and supportive of asset prices; policymakers acted with speed and aggression and seem poised to do more if financial markets or the economy falter; the aggressive use of fiscal and monetary policy justifies higher multiples; economic indicators have bottomed on a second-derivative level, and the "worst" is already priced in; and, the market has experienced a recession in a compressed amount of time given the drop in economic activity and depleted sentiment.