Moving in Stereo: Churn and Rotations Causing Swings in Sentiment

The stock market’s rally off the recent lows has been a welcome reprieve relative to the volatility-spiked pullback that began on “bleak Friday” alongside the COVID-19 omicron variant news. In keeping with ongoing rapid-fire rotations at the sector level, investor sentiment has been on a seesaw as well. In our 2022 outlook published at the end of November, we highlighted that sentiment was then in highly euphoric territory (a generally-contrarian signal).

We penned one of these sentiment-oriented biweekly reports in mid-November, which looked at several metrics that were then at opposite ends of the spectrum relative to where they are today. That mid-November level of complacency arguably laid some of the groundwork for the 4.4% pullback the S&P 500 experienced during the final week of November. That was slightly better than the 5.2% pullback that began on September 2 this year; but importantly, that was also preceded by lofty sentiment conditions.

With relatively muted index-level drawdowns year-to-date (YTD), sentiment swings have been a bit more dramatic. This may be partly explained by the much more significant stock-level drawdowns so far this year, as shown below. The data is updated since it was published in our 2022 outlook two weeks ago. As you can see, the average drawdown within the S&P 500 is near-bear market territory (-19%); while it’s much more dramatic within the NASDAQ and Russell 2000 (-42% and -38%, respectively).

Muted Index-Level Drawdowns Belie Massive Churn Under Surface

The nature of these rotational corrections is that pockets of weakness have been simultaneously offset by pockets of strength, which have kept index-level drawdowns more subdued. Indeed, in the case of the NASDAQ, most investors would probably prefer to have a -42% average member drawdown—but an index-level maximum drawdown of only -11%—rather than having the bottom fall out all at once with a 42% drop. This more benign scenario of weakness hasn’t kept investor sentiment from swinging sharply throughout the year, however.