Last updated: 09:12 / Tuesday, 25 August 2015
Analysis by Legg Mason

Sentiment Indicators Show Capitulation Arguing for a Likely Snap Back Rally Shortly

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Sentiment Indicators Show Capitulation Arguing for a Likely Snap Back Rally Shortly
  • Over the last several years the market has appreciated significantly and well in excess of underlying earnings growth making it vulnerable to disappointment
  • Sentiment indicators of market breadth show capitulation and are at extreme levels arguing for a likely snap back rally shortly
  • Based on history, we believe the market is in the process of making a low. However, the selling typically needs to be followed by a quick reversal with strong buying support indicating that prices have become low enough to attract strong buying demand

Markets across the globe are under pressure, with Asia and emerging markets seeing the worst year-to-date returns driven by a growing concern over China’s ability to manage its slowing economy and the related impact that is having on commodities and related industries.

In the U.S. the economy overall continues to grow at a moderate pace. However, weak manufacturing numbers and growing credit concerns, evident in high yield and other credit spreads, have combined with the China worries to cause a painful six percent drop in S&P 500 this week.

Scott Glasser, Co-Chief Investment Officer, Managing Director and Portfolio Manager at Legg Mason points out that ten-year U.S. Treasury yields dropped notably last week. “For the moment, deteriorating credit, falling commodity prices, emerging markets weakness and the potential for slower growth have become more worrisome to investors than the timing of fed fund increases”, explained.

Over the last several years, said Glasser, the market has appreciated significantly and well in excess of underlying earnings growth, making it vulnerable to disappointment. "We have had very little volatility in the broader market averages with no ten-percent correction for at least three years. This is rare from a historical perspective", commented Glasser.

“However it must be noted that this is a mature bull market in its 6th year and recently we have seen a narrowing of stocks still participating in the rally. The precipitous drop in individual stocks over past few months reflected lack of conviction by speculators. This was not evident in the broader market averages as a whole until this week. We will continue to focus on market breadth or participation as an indicator of market health in months ahead”, said the portfolio manager.

According to Legg Mason, the market decline has been somewhat equally spread across stocks and sectors as liquidations of exchange-traded funds (ETFs) to raise cash or reduce exposure have resulted in broad declines across portfolios. However, momentum driven names have experienced the worst declines.

“Sentiment indicators like put/call ratios and trin ratios which show breadth of market participation show capitulation and are at extreme levels arguing for a likely snap back rally shortly”, said Glasser.

Based on history, Legg Mason believe the market is in the process of making a low. However, the selling typically needs to be followed by a quick reversal with strong buying support indicating that prices have become low enough to attract strong buying demand. The quality (strength and broadness of participation of the rally) can typically provide valuable clues as to whether the bottom is likely to be durable longer term.

“We have maintained all year that after the last several years of outsized large returns it would logical to expect markets to digest past gains and grow into existing market valuation that was high by historical standards. Said differently, it was our belief that stock returns would be up modestly in 2015. While the risks may be higher, that continues to be our expectation”, concluded.

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