Sentiment Update: Volatility Is a Drag

Three. That is how many times the MSCI World Index has tested a low during the autumn spurt of this year’s correction. With such jarring moves, we would forgive you for thinking the correction is worse than its peak-to-trough -11.0% decline.^[i] Grinding moves punctuated with big swings have a way of looming large emotionally. Financial headlines seem to be feeling the blues, with many warning this could be the tip of the iceberg. Yet to us, this volatility still looks like a correction, not a bear market—and therefore not a time to flee stocks. One telltale sign, in our view, is the notable deterioration in various sentiment gauges.

As the old Warren Buffett line goes, the time to be greedy is when others are fearful—and the time to be fearful is when others are greedy. Accordingly, pessimism usually runs rampant during corrections—but not early in bear markets. Bear markets usually start gradually, lulling investors into complacency. Often investors are still euphoric, having enjoyed years of strong returns, and choose to dismiss warning signs like an inverted 10-year minus 3-month Treasury yield curve^[ii] or a negative trend in The Conference Board’s Leading Economic Indexes. Euphoria can be blinding. The gentle early declines don’t seem scary, creating a false sense of security. Deep pessimism typically doesn’t arrive until the bear market’s darkest days, which usually come in its final one-third or so. By then, it is usually too late for investors to do anything about, lest they risk missing the rebound. But when a correction strikes, sentiment usually darkens quickly. Sometimes corrections start while investors are already scared of some perceived negative. Other times, they start for no apparent reason, triggering folks to seek causes—and then get scared of what they find. The volatility, on its own, can also be enough to send sentiment reeling.

This seems to be where we are today as sentiment gauges across the developed world are falling. The American Association of Individual Investors (AAII) Survey recently showed pessimism at a 33-week high. A New York Fed survey showed Americans are more pessimistic about the economy and markets today than at any other time since President Trump took office. One measure of UK individual investor confidence recently hit a 23-year low. The Sentix, a measure of investor confidence in the eurozone, reached a 2018 low in November, falling for the fourth consecutive month and missing expectations. And a widely followed measure of institutional investor sentiment hit its lowest level since December 2012, when the eurozone was well into a recession and many (wrongly) feared America’s “Fiscal Cliff” combination of tax hikes and budget cuts. Meanwhile, most financial commentary has flipped negative, finding scary reasons for the drop and arguing more tough times lie ahead. There is now plenty of talk about this downturn potentially being a bear market—very different from media’s tone during this year’s earlier bout of volatility. Then, many commentators preached discipline. Now, we see suggestions for defensive positioning and arguments that cash reigns supreme.

Though this might sound counterintuitive, more prevalent negative sentiment could be a sign stocks are poised for a stronger rebound now than they got after this year’s early volatility. That recovery was slow, grinding on for months before the S&P 500 reached new highs in September. Global stocks never even made it back to late January’s high. So in a way, we suspect world stocks were still waiting for capitulation. With more and more sentiment indicators and media coverage turning dour, that may be drawing near. Renewed volatility may also help investors get over their long-running fears of tariffs and Brexit. With stocks falling as these stories swirl, investors have a chance to see the thing they fear seeming to have an impact. That can enable them to finally move on—a spent fear is a powerless fear.

While it may be tempting to sit out until fears fade, markets typically don’t justify this mentality. Corrections usually end as suddenly as they begin, often before the associated fears fully fade. Waiting for worries to subside could mean missing much of the rebound. Stocks don’t send an “all clear” signal before making big moves. This doesn’t mean the correction will end today, this week or this month. Corrections’ ends are as impossible to predict as their beginnings. Wednesday’s positivity could mark the rebound’s official start, or there could be more downside in store. But over time, as uncertainty fades and investors better see strong fundamentals, we believe stocks should have plenty of reasons to rise.