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Kass: Emotion Begets More Volatility

While animal spirits have risen over the past few months, I have a growing sense that the market is beginning to be overtaken by emotion and that a condition of greater volatility (which is a natural outgrowth of a complacent and almost universally upbeat consensus) might continue over the balance of the year.

Technical and sentiment warning signs are everywhere.

Technically, there are signs that momentum is flagging, small-caps have begun to underperform, financials are lagging and even some of the anointed, high-octane stocks have started to stumble.

I recognize that sentiment is an imperfect timing tool, but it reminds us (especially in an extreme) that investors are thinking alike. It is at that time that it usually pays to ask whether the prevailing optimistic consensus is too pat.

Today, most investors are confident, and there is little doubt that a consensus exists.

One respected strategist even took the optimistic view a step further last week by suggesting that investors cannot lose (i.e. not tapering is bullish but tapering also could be bullish because it will mean a stronger economy and higher earnings).

History shows that these declarations that sound too good to be true probably are too good to be true and that this sort of sentiment extreme often evolves into greater market volatility and rougher investment seas.

That said, almost every single measure of investor sentiment is in a cheery extreme. For example:

  • Investors Intelligence bears have hit the lowest percent since the April 2011 peak;
  • the AAII bears hit a low since November 2011;
  • the NAAIM weekly poll has reached the second-highest equity net exposure since 2007;
  • the CBOE 10-day put/call ratio has fallen to the second-lowest level since the September 2012 interim peak;
  • margin debt is at an all-time high; and
  • equity fund inflows have increased substantially in the last three weeks.

Increasingly, individual stocks have begun to experience routine (up and down) gaps in prices of 5%-10% (or more). It is not difficult to extrapolate these individual moves into likely greater volatility in the broader markets. The longer the market extends its advance, the higher the risk of at least a warning crack or a sudden reversal.

It is quite possible that the fear of return on capital (defined as the lack of fear to the downside and fear of missing the upside) will be replaced by the fear of return of capital (and a more concerned and even more realistic view of the downside).

Rising Emotions

"Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one."

-- Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds

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