Posted by Adam Turnquist, CMT, VP Chief Technical Strategist

Friday, April 21, 2023

Key Takeaways:

• Despite the S&P 500’s technical progress this year, investor sentiment and positioning remain significantly bearish.
• The lack of respect for the market’s recovery and continued investor angst are evident in S&P 500 futures positioning. Non-commercial net futures positioning (speculative trades) reached its lowest level since August 2011. The decline was due to a combination of long S&P 500 futures positions falling to their lowest level since 2006 and short S&P 500 futures positions climbing to their highest level since September 2022.
• Extremes in both short and long S&P 500 futures positioning are often found at major turning points for the market. The key word here is often, but not always.
• We found that on a one- to three-month basis, major peaks in long positioning (extreme bullishness) historically produced above-average returns that outpaced returns of major positioning lows (extreme bearishness) during this time window.
• When looking out to 12-month returns, major lows in futures positioning have historically produced respective average and median returns of 12.2% and 13.4%, outpacing the 12-month returns of major positioning highs.

No Respect

The market and Rodney Dangerfield have a lot in common these days – they both get no respect!

Despite the S&P 500’s technical progress powered by a 7.5% gain this year, investor sentiment and positioning remain significantly bearish. Cash in both retail and institutional money market funds are at record highs—aided by yields north of 4%—and recent fund manager data collected by Bank of America shows investors are the most underweight equities relative to bonds since the Great Financial Crisis.

There are plenty of reasons to question the current recovery. Valuations are running relatively high as first-quarter S&P 500 earnings are expected to decline for a second consecutive quarter, triggering a potential earnings recession. And speaking of recessions, the odds of a recession in the U.S. occurring over the next 12 months rose to 65% in March, according to a Bloomberg survey of economists. Uncertainty over the Federal Reserve’s (Fed) monetary policy path, tightening credit conditions due to the fallout from last month’s banking turmoil, interest rate volatility, declining leading economic indicators, contracting manufacturing data, and debt ceiling drama are just a few of the factors behind the increased recession probabilities and investor pessimism.

The lack of respect for the market’s recovery and continued investor angst are also becoming evident in S&P 500 futures positioning. As shown in the bottom panel of the chart below, the Commodity Futures Trading Commission (CFTC) recently reported that non-commercial net futures positioning (speculative trades) reached its lowest level since August 2011. The decline was due to a combination of long S&P 500 futures positions falling to their lowest level since 2006 and short S&P 500 futures positions climbing to their highest level since September 2022.

View enlarged chart

Futures positioning provides useful insight into investor conviction on both sides of the trade, making the CFTC data an applicable sentiment tool. And with most sentiment indicators, they typically work best at extremes. As you may notice in the chart above, extremes in both short and long S&P 500 futures positioning are often found at major turning points for the market.

The key word here is often, but not always, as we analyzed S&P 500 returns after all of the major peaks and troughs across long and short futures positioning since 2003. The average and median forward returns for each major futures positioning high (bullish extreme) and low (bearish extreme) are shown below.

View enlarged chart

On a one- to three-month basis, major peaks in long positioning historically produced above-average returns that outpaced returns of the major positioning lows during this time window. When looking out to 12-month returns, major lows in futures positioning have historically produced respective average and median returns of 12.2% and 13.4%, outpacing the 12-month returns of major positioning highs.

Finally, for illustrative purposes, we created a simple trading model that 1) enters long S&P 500 trades when net futures positioning crosses two standard deviations below the mean (extreme bearishness) and 2) enters short S&P 500 trades when net futures positioning crosses two standard deviations above the mean (extreme bullishness). Based on this framework, the model is always long or short depending on the crossover signals.

Since 2003:

• The model generated a total return of 87% for an annualized rate of return of 3.2%. For comparison, a buy and hold S&P 500 strategy returned 326% during the same period for an annualized return of 6.2%.
• Of the 17 trades generated in the model, the average return for each trade was 5.1% with eight trades producing positive results.
• The maximum drawdown of the model was 31%, occurring over a 69 weeks. For comparison, a buy and hold strategy during the same timeframe had a maximum drawdown of 56%, occurring over 73 weeks.
• Overall, the model showed positive absolute returns but significantly underperformed a simple buy-and-hold strategy. The underwhelming performance stresses the importance of using the weight of the collective technical evidence for forecasting price trends instead of a single indicator or sentiment gauge.

View enlarged chart

Summary

The market remains resilient as investors meaningfully repriced risk during last year’s +20% drawdown. Low expectations along with the potential end to the Federal Reserve’s rate hike cycle have helped the S&P 500 climb the wall of worry. Given the extremes in futures positioning, a breakout above resistance at 4,200 could spark a short-covering rally that drives the index back to the August highs at 4,300. Historically, we have also found that major lows in futures positioning have produced above-average returns over the following year.

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