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Investor Sentiment Eroding Globally – Is America Next?

Contributed by Sasha Cekerevac for Investment Contrarians:

With the S&P 500 close to its all-time highs, a common question is: will we see a pullback or a continuation in the bull market? This is obviously a very complicated question to answer, as investor sentiment in the S&P 500 can shift extremely quickly.

In addition, there is obviously no quantifiable method to predicting the future. However, we can look at various indicators that might give us information about what is probable.

While the S&P 500 has continued moving higher, with investor sentiment in America cautiously bullish, over the past month there has been a huge increase in volatility and pullback in emerging market nations globally. Both the stock and bond markets in the emerging nations have been hit significantly.

With increased speculation that the Federal Reserve will begin reducing stimulus, part of the global link is beginning to break down. Over the past two months, emerging market bonds have fallen approximately 6.3%, as investors begin exiting riskier assets.

Why does it matter what happens to investor sentiment in the emerging markets for Americans whose primary focus is on the S&P 500? There are several reasons.

The S&P 500 comprises some of the strongest companies in the world. Because of this, investor sentiment in the S&P 500 is usually the last to get hit. The first indications of trouble usually stem from the peripheral, smaller emerging market countries that are thin and illiquid.

When we see signs that investors are beginning to panic and sell positions in those sectors, and if things then don’t stabilize, the trouble can easily hit our shores. Don’t forget, a huge amount of earnings for the S&P 500 companies does stem from overseas nations—what happens globally eventually does impact American investors.

S&P 500 Large Cap Index Chart

Chart courtesy of www.StockCharts.com

The chart above, showing the S&P 500 and the iShares MSCI Emerging Markets ETF Index (NYSE/EEM), illustrates that although the emerging markets exchange-traded fund (ETF) is more volatile than the S&P 500, they do track fairly close together and in the same direction most of the time.

What worries me is the shift in investor sentiment on the emerging markets versus the S&P 500 over the past couple of months. Notice on the right-hand side of the chart, the S&P 500 has maintained near all-time highs, while the emerging market ETF has broken down substantially.

Investor sentiment for the emerging markets has clearly fallen apart, both for their stocks and bond markets. However, investor sentiment in the S&P 500 remains resilient for now.

That type of divergence cannot continue forever. Either investor sentiment will rebound in the emerging markets, or the S&P 500 will break down as well.

What could cause investor sentiment to increase in the emerging markets?

At this point, there seems to be more probable downside than upside. Many emerging markets are slowing, and if major central banks, such as the Federal Reserve, begin reducing monetary stimulus, this won’t be good for any of the stock markets.

Reduction in monetary stimulus will be especially bad if institutional investors are borrowing money to invest in emerging markets, because if interest rates are moving up with the Federal Reserve reducing stimulus, this will bring on more selling pressure as positions need to be closed.

If that’s the case for emerging markets, investor sentiment could also get hit for the S&P 500. With the probability increasing that the Federal Reserve will begin reducing quantitative easing by the end of the year, at least marginally, this will bring on a substantial amount of volatility and, I believe, a broad market sell-off.

I think it is far more likely that investor sentiment in the S&P 500 will erode as the Federal Reserve begins to reduce its aggressive monetary policy program.

This will bring on a substantial amount of selling pressure, as investors book their profits and move into cash as a safe harbor. I think that this divergence in investor sentiment between the S&P 500 and the emerging markets is a warning sign that investors should heed. Contributed by Sasha Cekerevac.

Wolf here: Junk bonds had a phenomenal run. With each truckload of money that the Fed delivered to the markets, valuations soared and yields plunged. Desperate investors, mauled by the Fed’s zero-interest-rate policy, took on risks no questions asked. But suddenly the feeding frenzy turned into a brutal rout – a harbinger of things to come in other markets. Read... The Day The Big Fat Junk-Bond Bubble Blew Up

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