Sentiment, Expectations, & Risks
By Adam Thurgood on January 14, 2025
Financial markets are complex systems with uncountable moving parts that all impact the outcomes in varying weights. Given the complexity of markets, it’s virtually impossible to have certainty about any given outcome or to win every bet. Instead, the game is one of probabilities, where market participants attempt to position themselves in a manner that improves their odds of success. Over the years, we’ve drawn on numerous research sources to build a variety of models that help us assess market regimes in an attempt to improve our odds of success. In this piece, I will dive into our sentiment model, look at expectations priced into markets, and discuss the risks we currently face.
In simple terms, sentiment is about feelings. However, there are lots of ways to measure sentiment, such as bullish/bearish surveys, investor positioning, etc. Our sentiment model uses market prices for an index/equity over a period of time relative to the current price to see, in aggregate, whether investors feel good or bad about their trade in that particular index/equity. When the current price is above the aggregate price investors paid, sentiment is positive, and vice versa. Using this segmentation, we can look at the risk/return tradeoff of each category to see if there are important regime differences that should be factored into investment decisions.
Generally speaking, when markets are in the positive sentiment regime, risk-adjusted returns tend to be much better than in the negative sentiment regime. Take a look at the chart below of the S&P 500 (on a log scale), where the red bars highlight periods of negative sentiment. One quick glance will demonstrate that you want to avoid being overextended in such periods and be more aggressive when sentiment is positive.
Breaking the data down into a risk/reward scatter plot, we can see that not only are expected returns higher during periods of positive sentiment, but the risk is also lower. This doesn’t mean that only great results occur in a positive sentiment regime or disasters in a negative sentiment regime. However, it does help to determine when the odds are stacked in your favor to take on more risk.
As of the close of the week on January 10th, the S&P 500 remains in a positive sentiment regime. This has been the norm for some time. In fact, our S&P 500 sentiment model has only been in a negative sentiment regime in four of the past 104 weeks! However, we are much closer to flipping than we have been in over a year. At this point, another rough week of trading could do it.
While a flip into negative sentiment wouldn’t be a death spell for markets, it would be concerning given where expectations and valuations currently sit. According to Bloomberg, as of 1/10/25, S&P 500 earnings are expected to grow by 10% over the next twelve months, 14% the year after that, and another 10% the following year. Those are attainable but lofty expectations. The issue with lofty expectations is that they become harder and harder to beat yet easier to disappoint. That creates a form of asymmetry that isn’t favorable.
On the valuation front, it’s hard to argue that US stocks are cheap. One of Warren Buffet’s favorite indicators of stock market value is the market cap to GDP ratio. His belief is that over the long run, the two metrics should be roughly equal. Therefore, if you can buy stocks when the market cap to GDP ratio is 80% or below, you’re getting a great bargain. Today investors can buy the US market at the paltry price of 203% market cap to GDP. Given this backdrop, it is no wonder that Warren Buffet is sitting on his highest cash level in history.
When looking at the US market relative to other important markets of the world, the US clearly has robust earnings and sales growth estimates, but it also commands a much higher multiple. The size of the bubbles in the chart below depicts the forward 12-month P/E ratios. While market participants are paying top dollar for US exposure, Europe and Japan are trading at much lower multiples, which may be warranted given the weaker growth dynamics. Emerging markets have much lower multiples than the US, despite a similar growth profile. Emerging markets have almost always traded at a discount to the US due to less certain property rights, political instability, etc., yet the spread has become quite wide, especially to individual markets like China and Brazil.
On a price to sales basis, the story is similar. The US market is near all-time high valuations, mainly due to rocketing valuations on the heels of US tech dominance, while other markets around the world have had subdued performance. Yet valuations can only go so far before they become silly. Take, for example, that the US represents about 5% of the world’s population, 25% of world GDP, 38% of the world’s corporate earnings, yet the US market represents between 65-70% of world market capitalization. The valuation extremes have become so wild that just two stocks in the US, Apple and Microsoft, have a combined market cap greater than the entire Japanese stock market. Given these extremes, one has to wonder how much further it can go.
Valuations alone are not great indicators of near-term price moves. However, they matter a great deal for long-term returns, and they provide an indication of the margin of safety in an investment. Today, with valuation levels at or near all-time highs and expected double-digit earnings growth as far as the eye can see, there is a lot of potential risk in the US market. With the sentiment model still in positive territory, the immediacy of these risks seems less pronounced but should the model flip to negative, the odds of a nasty correction will rise.
