6 Signs of Extreme Stock Market Optimism

VIX has closed in single digits in all but one trading session this year

Jan 11, 2018 at 1:03 PM
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Coming off a historical 2017, the U.S. stock market has started 2018 with a bang. In fact, the Dow, S&P 500 Index (SPX), and Nasdaq Composite (IXIC) each hit new record highs in each of the first six trading sessions of the year -- a first-time feat for the major benchmarks. Against this backdrop, several sentiment indicators are pointing to levels of extreme optimism in the stock market. However, there are still pockets of pessimism to be found, suggesting investors are not yet displaying the euphoria that often defines a market top.

Stock Market Optimism is Nearing an Extreme

For starters, TD Ameritrade (AMTD) said its Investor Movement Index jumped for a second straight month in December, ending 2017 at 8.59 -- an all-time high. In other words, retail investors closed out last year with record-high exposure to the stock market.

Elsewhere, last week's American Association of Individual Investors (AAII) survey showed 60% of respondents were bullish on the market, compared to just 15.6% that were bearish -- pushing the difference between the bulls and bears above 40% for just the second time since 2010. Plus, this reading is in the 96th percentile of all readings taken since August 1987, pointing to extreme optimism and flashing a caution sign for stocks, according to Schaeffer's Senior Quantitative Analyst Rocky White.

A Jan. 9 cover story in the Wall Street Journal entitled "Investors Drop Shields Against Stock Downturns" noted how demand for put protection (subscription required) is low, and "many doubters are shedding caution as the long rally rolls on." Put options are often used as a defensive position to protect paper profits against any unexpected risk.

This lack of fear is being reflected in the CBOE Volatility Index (VIX), too, which hit an all-time low of 8.56 last year -- and notched its lowest annual high (17.28) of the past 20 years. Plus, it was the fourth straight year in which the VIX declined. Amid today's stock surge, VIX is down 1.3% at 9.69, pacing for its seventh close in single-digit territory this year out of eight sessions.

Meanwhile, the latest Investors Intelligence (II) survey showed the the percentage of bullish advisors jumped 2.5 percentage points to 64.4% -- matching the 20-year high reading from last November. Likewise, the percentage of bearish advisors fell 1.7 percentage points to 13.5%, the lowest reading since August 2014. The bulls-minus-bears line is above 50% for the first time since January 1987, and at its highest point since March 1986. We typically view readings of 40% or more to signal extreme optimism.

Lastly, according to Bespoke, the rate at which analysts have upwardly revised earnings-per-share (EPS) estimates for S&P Composite 1500 Index stocks hit its highest level in a decade. Most recently, analysts raised EPS guidance for 757 companies, or 31.1% of stocks in the index, eclipsing the previous high of 30.47% set in May 2010.

Euphoria Has Yet to Be Reached

However, not everyone has climbed on board the stock rally yet. In this week's Monday Morning Outlook, Schaeffer's Senior V.P. of Research Todd Salamone underscored the large short interest on SPX component stocks, which began building in February 2017 and ran through mid-September. Should the broad market continue to rally, "short covering could keep momentum trades intact," according to Salamone.

Additionally, the National Association of Active Investment Managers (NAAIM) survey fell to 57.95 last week -- its lowest reading since Nov. 15. In the past three weeks, the reading has dropped 51.5 points, the largest 21-day decline since Jan. 16, 2008, according to Schaeffer's Quantitative Analyst Chris Prybal.

While the extreme levels of optimism spark uncertainty in the current market -- especially with fourth-quarter earnings season kicking off tomorrow -- sentiment is still not at the levels of euphoria found at tops. Salamone continues to "advocate call options to play the upside in this market, as the lower dollar commitment, combined with leverage, addresses perceived risks."



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