What Direction is the Pain Trade?, May 16, 2017

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Longer term readers know that one of the better indicators we use to determine the near-term trend of markets is the “pain trade,” and figuring out whether the pain trade is higher or lower can help us determine whether the near-term risk for stocks is for a breakout, or a pullback.

For reference, the pain trade is an industry term that describes the most painful market outcome for investors. It’s based on the simple (and accurate) principle that the market always moves to extract the most amount of pain from the most amount of people.

So, if the most amount of people are long and positioned for higher stock prices, the pain trade is lower. Conversely (as has been the case for most of the 2010s), when investors are underweight equities and are cautious and expecting a correction, the pain trade is actually higher, because investors lament underperformance and are “missing” the rally.

We think that after years of the pain trade being higher, we are approaching a turning point where the pain trade will once again move lower, like it was for most of the 90s and 00s, and we wanted to cover the reasons behind that observation. This matters, because if, in the coming months, the pain trade does turn lower, that will effect how we are positioned.

When determining which direction the pain trade lies, I look at

1) Sentiment and

2) Investor exposure to stocks.

Again, as a general rule, if sentiment is bullish/positive and investor exposure to stocks high, the pain trade is lower, meaning a drop in stocks elicits the most pain from the most people.

Conversely, if sentiment is skeptical/cautious and investors are underinvested in equities, the pain trade is higher, meaning a rally in stocks elicits the most pain from investors as they are “missing” the rally.

Investor Sentiment: No Irrational Exuberance, but the Multi-Year Caution is Eroding. Various measures of investment sentiment are simply not signaling an undue amount of euphoria out there at this time.

Put/Call Ratios are in the middle of the historical range (and well above the 0.45% that represents excessive bullishness). Meanwhile, the AAII Sentiment Survey (American Association of Individual Investors) shows just 32.7% bulls, well below the historical average of 38.5%. Again, that’s not the type of extreme bullishness that would make the pain trade lower.

However, not all sentiment indicators are cautious. The Investors Intelligence Advisor Sentiment Index is above 3.0 (the level that denotes excessive expectations of higher stock prices) and the percentage of bullish advisors is creeping towards the peak of 60% (currently 58.7). So, it would appear that advisors are a bit more bullish than options traders or individual investors. But, it’s still a mixed picture, and doesn’t imply the pain trade is materially higher or lower.

Takeaway: For the past several years, market skepticism has helped power stocks higher; but while the expectations of investors and advisors has turned more positive (and hence reduced the upside pain trade) it is still not bullish enough to make us think the pain trade has turned definitively lower near term, yet.

Investor Exposure to Equities: Getting More Long. Underinvestment in the stock market also has been a powerful tailwind on stocks over the past seven years, as cautious investors have been waiting for another financial crisis (one that’s yet to arrive). So, with each new high, investors and advisors have “chased” stocks higher after throwing in their bearish towels and finally getting back in the market.

That’s one of the reasons super-cap internet and tech stocks have outperformed. Those stocks are called “long rentals,” because they are ultra-liquid and are positively correlated to the market in general and tech specifically. It’s an easy, general way to get a client more long the market in a hurry without taking too much risk.

However, now, that broad market underinvestment situation also has somewhat resolved itself. Since October we’ve seen consistent inflows into US mutual funds and ETFs, including in April (if we ignore the large outflows during the first week of April, as people liquidated accounts to pay taxes, contribute to IRAs, etc.)

Additionally, the amount of money market fund holdings over the previous year.

Takeaway: The extreme levels of underinvestment that prompted investors and advisors chasing markets higher has not been eliminated, but it has been seriously reduced… and that also reduces the upward direction of the pain trade.

Bottom Line

For years, the pain trade has been higher due to cautious/pessimistic investors who were burned by the financial crisis, combined with lots of dry power in the form of equity market underinvestment. However, while the pain trade likely is still marginally higher, it is not the bullish force that it once was. As such, we do not expect to see stocks magically grind higher in the face of unimpressive fundamentals the way we did over the past several years.

From a practical standpoint, this analysis reinforces our cautiously positive opinion on stocks, but also restrains us from chasing stocks without evidence of a reignited reflation trade. Bottom line, the pain trade now is much more two sided than it has been in years, and that puts even more emphasis on getting the political and economic analysis right—because at this point just as much pain will be elicited from investors if we roll over, or if we breakout.

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