This Rally Seemed To Come Out Of Nowhere. It Didn’t.

A great recipe for a stock market rally is to add overly bearish sentiment to overly bearish positioning, and then stir in a catalyst. That’s what happened last week, as that pessimistic blend came together with fresh hopes that interest rates had peaked. The mixer went down smoothly – it was the market’s best week all year. So let’s take a look at the indicators to see whether this rally might stick around and consult a handy AI tool to see what opportunities may be out there...

What do the indicators say?

To make a clear comparison, let’s check out the same three indicators we looked at in July, which resulted in a timely bearish call. And, as always, let’s keep in mind that past performance is no guarantee of future success.

First, let’s look at the National Association of Active Investment Managers (NAAIM) Exposure Index. It reveals how much skin its members have in the stock market game at any given time. Not, it’s not intended to be predictive, but it does shed some light on what kinds of adjustments active risk managers have made in recent weeks.

The National Association of Active Investment Managers (NAAIM) Exposure Index, from December 2021 until this month. Source: NAAIM.

The index currently sits around 29, a low not seen since October 2022, just before a market rally that saw a peak in bearish sentiment. When positioning reaches extreme levels – in this case, bearishly – it can indicate that there are fewer new sellers who could force the market even lower.

Second, let’s look at the CNN Fear and Greed Index. The popular gauge of market sentiment was pointing to extreme greed back in July, and that was a big part of my bearish leaning at the time. But right now, the index is pointing decisively toward fear. This may be a good time to remember Warren Buffett’s sage advice: “be fearful when others are greedy, and greedy when others are fearful.”

The Fear and Greed Index is currently pointing to fear in the market. Source: CNN.

The index has moved out of the extreme fear region in the past month, but the fear zone continues to lend support to the argument that few participants are positioned for a rally. And that means there’s the potential for new buyers to come around and push the market higher.

And third, let’s look at the American Association of Individual Investors (AAII) Sentiment Survey for the seven days ending November 1st. It shows that most investors were expecting stocks to fall over the next six months.

The AAII Sentiment Survey indicates a widely bearish sentiment for the six-month market outlook. Source: AAII.

As you can see, more than 50% of individual investors are bearish on the outlook. It’s not quite as high as we saw in December 2022, but it does suggest that market sentiment is very downbeat.

Together, these indicators point to a trifecta of bearishness, a total reversal of what we saw in July this year.

Other indicators tell a similar story. Goldman Sachs’s data recently showed that hedge funds are less “net long” on US equities than they’ve been in 11 years, and Barron's Big Money poll showed that only 12% of clients are feeling bullish.

So what’s the opportunity here?

Remember, the catalyst ingredient that sparked the market’s rally last week was the expectation that the US has finally reached a peak in interest rates. And we can’t really answer the question just yet about whether this was the start of a new bull market, or just a bear market rally. Bear market rallies often do see big price moves as hedge funds and other traders become forced to cover their short positions. And those rallies can last for a reasonably long time and result in fairly hefty gains.

Back in July, we checked in with Danelfin’s AI ETF and stock-picking software, to find out its top ten ETF picks. Most were bearish ETFs – the kind that increase in price when markets fall. And those turned out to be a pretty good call as stocks sharply sold off soon after. So I screened the fintech’s 687 ETFs again this week to see which ETFs currently top the list.

Danelfin’s top ten North American stock ETF picks. Source: Danelfin.

Take a look at the technical score: it’s the best indicator when using Danelfin’s predictive AI to rank ETFs. As you can see from the chart, the top ten picks include a wide variety of sectors and styles. But value investing features prominently, with the SPDR S&P 600 Small Cap Value ETF (ticker: SLYV; expense ratio: 0.15%), the Invesco S&P 500 Pure Value ETF (RPV; 0.35%), the iShares S&P Small-Cap 600 Value ETF (IJS; 0.18%), and the SPDR S&P 400 Mid Cap Value ETF (MDYV; 0.15%) all ranked. As Carl noted here, value stocks are cheap, so adding some to your portfolio might be a good idea.

The Invesco KBW Bank ETF (KBWB; 0.35%) also made the top ten. And that’s particularly interesting right now: PIMCO co-founder Bill Gross revealed last week that he was buying some regional banks, saying they have extraordinary long-term value. But the legendary investor added that he was waiting to own some of them at 60% of their book value. The Invesco KBW Bank ETF has been battered recently because of concerns about commercial real estate exposure and bond losses. But remember, in a bear market rally, sometimes those companies that have been hit the hardest rally the most because they’re shorted by hedge funds and are under-owned.

Rounding out Danelfin’s top ten list are more speculative ETFs – ones that invest in companies that have long horizons to reach profitability and that are vulnerable to higher interest rates. So if you are feeling speculative, the SPDR S&P Biotech ETF (XBI; 0.35%), the ARK Genomic Revolution ETF (ARKG; 0.75%), and the Global X Genomics & Biotechnology ETF (GNOM; 0.5%) could be worth a look.