There are many defensible rationales for selling stock markets that seem overloved: 

  • If everyone’s invested, the market has fewer potential buyers (to push prices higher) ...
  • More potential sellers (to push prices lower) ...
  • And a sizable population of skittish “dumb money” retail investors (most of whom presumably bought in the waning days of the rally, stretching valuations to an extreme).

That’s why hot markets, while seductive, can also be dangerous. The S&P 500 Index isn’t there yet, per se, but it’s easy to understand why some investors might think it is after the index rose 20% from its bear-market bottom in October, meeting the popular definition of a bull market.

Some investors seem positively giddy. The American Association of Individual Investors’ survey, one of the classic contrarian indicators, now shows net bullishness among retail investors at its highest since November 2021 — about two months before the nosebleed-top of the market in January 2022.

Meanwhile, the State Street Investor Confidence Index for North American institutional investors — derived from actual trades rather than survey responses — rose in May to its highest in six months. That was its biggest one-month increase since February 2022.

All the while, short sellers are nowhere to be found:

By its nature, contrarian investing tends to be at odds with the view of the market as an efficient discounting mechanism. If the market is always right, you shouldn’t be able to make money betting against it. But instead of viewing stocks as efficient and all-knowing, contrarians see the market as a crowd of fallible individuals susceptible to overreaction and herd mentality. When everyone zigs, they zag, and they must be tempted to do so right about now.

The value-to-fear ratio — the S&P 500’s forward price-earnings ratio divided by the Chicago Board Options Exchange Volatility Index, or VIX —currently shows multiples rising swiftly while “fear” is dropping like a rock, another popular contrarian signal that markets are drifting in the direction of La La Land. The last time value-to-fear was this high was November 2021 (sound familiar?).

Historically speaking, the current ratio of 1.44 is not outrageously high (about one standard deviation above the 30-year average), but the economic context clearly casts it in a more concerning light. Below, I’ve combined the inverse value-to-fear ratio — which we can simply call fear-to-value — with the Survey of Professional Forecasters Anxious Index, the Philadelphia Fed’s gauge of economists’ views on perceived recession risk in the next quarter. The chart shows how they typically move in lockstep, except for 2023, which is experiencing an extremely rare combination of very concerned economists with relatively heedless markets. Somebody has to be wrong.

Of course, evidence for the usefulness of such metrics is mixed. If you sold the S&P 500 every time value-to-fear got into the cheap seats (two standard deviations above the mean), you would have liquidated your stock portfolio at the end of 1995 and missed out on the lion’s share of the 1995-2000 rally. Then, as now, investors were diving back into the market toward the end of a stretch of monetary policy tightening, and the overly cautious contrarians were left in momentum traders’ dust. You can’t blame people for worrying that this could be a repeat of that episode.

Value and fear aside, there’s a special reason to shy away from euphoric markets in inflationary times like these: Rallies can draw the Federal Reserve’s ire. Indeed, some Fed leaders over the years have viewed them as being at cross-purposes with their goals of cooling the economy to rein in high and volatile prices. Growing portfolios are associated with increased household wealth, and if households decide to spend more freely because of perceived wealth gains, they may provoke the Fed into raising interest rates further. Here’s former Fed Chair Alan Greenspan on his concerns about “wealth effects” in March 1995 (emphasis mine):

If you remember, some of our discussions about the necessity of moving in early 1994 recognized that we were beginning to get wealth effects that were unsustainable and potentially creating bubbles. Ironically, the real danger is that things may get too good. When things get too good, human beings behave awfully .

There’s much debate about the size of the equity wealth effect because only around 60% of Americans own stocks, and they tend to skew richer (with a lower propensity to spend from each marginal dollar of wealth). Reasonable estimates place the wealth effect somewhere in the range of a few cents on the dollar. When consumption and stock prices are both rising in a bull market, it can be difficult to determine what is causing what. That’s perhaps why mentions of the effect have basically disappeared from the Fed minutes. But equities still figure into the monetary policy debate insofar as they are part of many broad “financial conditions” indexes, which are used to help judge how the Fed’s policies are playing out in the real world.

For now, it’s impossible to know whether the new “bull market” has legs. The practice of declaring a bull after a 20% rally — which many analysts and market-cycle researchers find arbitraryand unhelpful — has led to several fake-outs over the years (1948, 2001, 2002, 2008), when markets hit the milestone and then subsequently retreated to lower lows. In other cases (the entire period from 1967-1982), the market rallied into a bull market but failed to advance in a meaningful way for years afterward.

Whether you call this market a bull or not, a lot of retail investors are falling in love with it. And while no one’s calling them crazy, you can’t really fault the contrarians for taking the other side of that trade, either.

This article was provided by Bloomberg News.