Getting a grip on market sentiment can help you figure out where stocks are likely to go next, and Goldman Sachs says it’s refined a tool that will allow you to do just that.
Portfolio strategy associate Arjun Menon said the firm tore down and revamped its sentiment indicator to include nine different measurements of how investors were positioned in stocks. In a recent note to clients, Menon said the new sentiment indicator captured more detail and did a better job predicting the market’s direction.
As it stands now, the updated indicator shows that the benchmark S&P 500 is on track for a decline of at least 2% in the next eight weeks, he said. If positioning stays the way it is, and the economy doesn’t improve, it could pose a larger obstacle for the market in the future.
“The likelihood of a positioning-driven sell-off in the near-term has increased,” he wrote. “If economic growth remains modest, extreme positioning could hamper stock returns going forward.”
In the past, Menon said, Goldman measured sentiment using data from the Commodity Futures Trading Commission. Now it’s complementing that with eight other types of data to get the most accurate picture of how households, hedge funds, active mutual funds, foreign investors, and others are investing.
Combined, those groups own 80% of stocks, Menon said. He said the updated sentiment indicator has been rising for three weeks and was giving off a “stretched” or high reading. Because sentiment is a contrarian indicator, that’s a negative signal for stocks.
Menon said net exposure by hedge funds hasn’t been this high since July 2018, and demand from foreign investors has risen to its highest level since March.
“Aggregate equity positioning is 1.2 standard deviations above average, indicating that positioning poses a downside risk to S&P 500 returns in the near future,” he wrote. Here’s what the new sentiment indicator is showing:
Regression analysis lets Goldman link the positioning data to subsequent market performance dating back to 2008. It says extreme readings like the current ones are a negative indicator lasting five to eight weeks.
Menon added that the additional sources of data gave the new sentiment indicator much more predictive power than the old one, lending more weight to his forecast of short-term declines. He added that the new indicator was more accurate than the old one when positioning is light, and similarly effective when positioning is stretched.
Still, he said the high levels of sentiment weren’t necessarily a disaster because if economic growth were to get stronger, it would support higher stock prices. That’s what he expects, and he maintains a year-end target of 3,100 for the S&P 500.