I Asked An AI Tool What It Thinks About The Stock Market Rally

Most of the rally in stocks this year has been driven by excitement about AI, so it makes sense to turn to an AI tool to see what it has to say about the rally itself. I used Danelfin’s predictive technologies to get an AI view, and compared that to the latest market positioning data and investor sentiment surveys. Here’s what I found…

What does the AI tool say?

Danelfin’s AI-driven analytics tool uses AI, machine learning, and other big-data tools to crunch tons of data and give regular investors access to the kind of information that institutional investors have. It calculates an AI score between one and ten to rate a stock or an ETF’s probability of beating a market index (the S&P 500 for the US) over the next three months. The AI analyzes more than 10,000 features per stock or ETF every day, based on more than 900 fundamental, technical, and sentiment indicators. But the AI score it spits out is not just the average of the subscores: it’s a predictive score based on all the data available for a stock or ETF.

Here’s a breakdown of what each of the scores (1-10) means in terms of ratings and expected alpha, (i.e. how it might perform relative to the market index). Source: Danelfin.

Ideally, you’d want to find assets that draw an AI score of ten, as that provides the best potential returns. Any score from seven to ten can be considered a buy, while a score of three or below can be considered a sell.

Right now, Danelfin tracks 2,045 listed ETFs. And these are its top ETF picks:

Danelfin AI’s leading ETF picks. Source: Danelfin.

It’s notable that eight of the top ten are bearish ETFs that gain if stock markets fall. (The other two are bullish ones that track palladium and energy.) The current top pick is the Proshares UltraShort S&P 500 (ticker: SDS; expense ratio 0.75%), which is an ETF that corresponds to twice (200%) the inverse (opposite) of the daily performance of the S&P 500 Index. The last time it had a score of ten was on February 1st, 2022.

Danelfin’s AI score for the ProShares UltraShort S&P 500 ETF. Source: Danelfin.

At the time, the S&P 500 was in the early stages of a sharp selloff, so the AI score of ten turned out to be a good indicator.

The S&P 500, from November 1st, 2021, to July 24th, 2023. Source: Bloomberg.

Now, as you’ve no doubt heard before, past performance is no guarantee of future success, but the fact that Danelfin’s AI is again signaling the attractiveness of bearish stock ETFs is definitely worth paying attention to.

And what does market positioning suggest?

There’s no sense looking at AI scores (or any other single metric) in isolation. The National Association of Active Investment Managers (NAAIM) produces the NAAIM exposure index, which reveals how much skin its members have in the stock market game at any given time. It isn’t meant to be predictive, but it does shed some light on what kinds of adjustments active risk managers have made to client accounts over the previous two weeks.

The NAAIM exposure index shows the average amount of exposure to the stock market that’s reported by the group’s members. Source: NAAIM.

Exposure is currently at 99.05% (blue line), the highest level since November 2021, which was just before a sharp stock market selloff. This positioning is pretty revealing: while most active fund managers were underweight stocks at the beginning of this year, these pros have increasingly been buying stocks and helping to drive the market rally. According to this gauge, at least, most pros now look to be near full stock allocations, so they’re less likely to be the marginal buyer in the market. See, for stock markets to rise, they need new buyers who are willing to pay higher prices.

And that tracks with what the fear and greed index is currently indicating: it’s pointing toward extreme greed. That usually doesn’t bode well. And, sure, the stock market has performed well this month despite already being in extreme greed territory, but, still, you might want to take this as a warning.

The fear and greed index is currently pretty unambiguous about market sentiment. Source: CNN.

The fear and greed gauge takes seven factors into account, five of which are pointing to extreme greed. They are: market momentum, stock price strength, stock price breadth, safe-haven demand, and options to buy, or “calls”, being favored over options to sell, or “puts”. Only one factor – junk bond demand – registers regular, non-extreme greed. And volatility is the sole factor offering up a neutral reading.

In other words, there’s a bandwagon here and it feels like everyone is on it. The American Association of Individual Investors (AAII) sentiment survey for the seven days ending July 19th showed that most investors think stocks are going to rise over the next six months. Indeed, optimistic, or bullish, sentiment jumped 10.4 percentage points to 51.4%, flying way above its historical average of 37.5% and hitting a high not seen since April of 2021.

The AAII sentiment survey shows bullish sentiment having its longest above-average streak in over two years. Source: AAII.

What’s the opportunity?

Living legend Warren Buffett has said you should “be fearful when others are greedy and greedy when others are fearful”. And that suggests this is a time to be fearful. See, when everyone is positioned for a rally, it begs the question: who is left to join the party? So if you’re leery about chasing the stock market at current levels, you might instead look to hedge your exposure using S&P 500 Index “put” options – and, good news, they’re cheap right now, with volatility so low and investors so bullish.

But keep in mind, fearfulness needn’t keep you out of stocks altogether. After all, the recent declines in inflation could be good for the stock market and the economic outlook. You might just want to opt for another way to play the market. Since the rally this year has been heavily concentrated in big-cap AI-related stocks, you might consider gravitating toward the stocks and sectors that have struggled this year, perhaps considering the Invesco S&P 500 Equal Weight ETF (RSP; 0.2%). Sometimes, going at least partially with the greedy consensus can be a good way to make money.