Stocktake: Bearish sentiment may worsen – Merrill

Sell on the bounce Market sentiment may be awful but investors are not yet "max bearish", indicating any bounces should be sold.

So says Merrill Lynch, whose latest monthly fund manager survey reveals institutional investors are "no longer in denial" but remain "stubbornly long" assets most vulnerable to a market "shakedown", namely European, Japanese and technology stocks.

Risk appetite has dived to well below normal readings but remains above 2011-12 levels. Additionally, just 12 per cent expect a recession over the next 12 months.

Nevertheless, sentiment is bearish and at levels normally associated with market rebounds. Cash balances have risen to 5.4 per cent, the third- highest reading since 2009. Equity allocations have plunged; since 2009, allocations have only been lower four times, all of which were near market bottoms.

Ordinary investors, meanwhile, are throwing in the towel, with bullish sentiment among American Association of Individual Investors (AAII) hitting a 10-year low.

This fear is all too evident in markets, with intra-day trading ranges at their highest levels since 2009.

Many of the ingredients for a counter-trend rally are in place. Still, any rebound may well, as Merrill suggests, be greeted with another wave of selling. Major declines unlikely Investors have been scarred by the vicious bear markets of 2000-02 and 2008-09 but the current downturn is unlikely to be so traumatic.

That's because for now, a recession looks unlikely. Yes, stocks can suffer unpleasant sell-offs and even bear markets in recession-free environments; since 1939, there have been 16 such cases, notes investment strategist and blogger Ben Carlson, with stocks suffering average declines of 19.4 per cent (just shy of official bear market territory).

Over the last 50 years, however, there have been just two recession-free bear markets.

The first (1966) lasted eight months and was triggered by rapidly rising interest rates, notes Urban Carmel from the Fat Pitch blog; the second (1987) lasted three months and followed a period of unsustainable equity euphoria. Neither case resembles the current environment.

Obviously, the S&P 500 is already teetering on the brink of a bear market, but a protracted decline appears unlikely. Markets topped in May, so if this is a bear market, it may already be in its latter stages.

There is, however, one caveat: if recession really is around the corner, then uglier declines can be expected. Bear market is quite old The aforementioned duration of the current correction, now eight months old, is easy to miss. After all, the S&P 500 ended 2015 within touching distance of May's all-time high.

All seemed calm, only for indices to suffer a sudden January plunge amid a fresh outbreak of China-induced panic. It’s important to remember, however, that stocks have actually been in corrective mode for some time now, so much global economic weakness is already priced into stocks. Energy stocks have been falling since mid-2014; the Euro Stoxx 600 and the MSCI World index are already in bear markets, having peaked last April and May respectively; most S&P 500 stocks are also in bear markets.

The same picture emerges from Merrill Lynch’s aforementioned monthly fund manager surveys, with cash balances above 5 per cent for six of the last seven months – a run unseen since 2008-09.

The recent troubles represent an escalation rather than an initiation of market frailty.

“Is this the start of a bear market?”, Time magazine asked last week.

The answer is no – the bear market started a long time ago and may be closer to its end than its beginning.

Will Fed run to the rescue? Steep declines in non-recessionary environments are usually brief affairs, as mentioned earlier.

The three standout cases in recent decades occurred in 2011 (a 19 per cent decline), 1998 (also 19 per cent) and 1987 (33 per cent); none of those periods lasted longer than five months.

Brevity aside, they had another feature in common – the catalyst for each subsequent market upturn was Federal Reserve easing.

Will history repeat itself? The Fed raised rates in December, so a sudden U-turn would be an embarrassment, but it’s possible.

Ray Dalio of Bridgewater, the world's biggest hedge fund, last week called on the Fed to "remain flexible", saying renewed easing would "bolster psychology". The Fed has long been sensitive to market movements. If the despondency persists, calls for Fed chief Janet Yellen to run to the rescue will grow louder.