Why the ‘pain trade’ explains the stock market’s continued rise despite bad news

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Confounded by a 2023 stock-market rally in defiance of rising geopolitical tensions, a mini banking crisis and widespread expectations of near-imminent recession?

You’re not alone — and that’s the point.

The stock market’s resilience so far in 2023 is an example of a well-worn but sometimes useful market concept known as the “pain trade.” Tom Essaye, founder of Sevens Report Research, defined it succinctly in a Tuesday note: “The goal of the market is to extract the most amount of pain from the greatest number of people.”

As he explained, that means when everyone is bearish, the pain trade will be for stocks to move higher. And when everyone is bullish, for stocks to move lower.

“As such, the pain trade has been higher for all of 2023 and that’s helping support stocks despite decidedly mixed fundamentals (and mixed is being generous),” he wrote.

Measures of investor sentiment help to tell the story.

A month ago, in the wake of the failures of Silicon Valley Bank and other regional lenders, the widely followed CNN Fear and Greed Index tumbled to 28, deep in the “fear” category and just shy of “extreme fear,” Essaye noted. He added that the AAII’s Bulls/Bears Sentiment Index dropped to -28%, a level so deep into negative territory it’s often described as a contrarian buy signal, while the Investors Intelligence Advisor Sentiment Survey fell to 12.5%, a level that signals caution.

“That wide expectation of looming calamity, and the fact that it hasn’t come to fruition yet, has been a material contributor to equity resilience, because it’s made the pain trade higher as investors waiting for a decline that never occurred, and who are now chasing stocks higher as they remain resilient,” Essaye wrote.

Away from those sentiment indicators, Bank of America’s monthly survey found global fund managers the most pessimistic they’ve been all year, even as stocks traded not far off their best levels of 2023.

Indeed, the S&P 500 index was up 7.7% through Monday from its March 13 settlement, which marked its lowest close of last month just after SVB’s March 10 failure. The large-cap index is not far off its high of the year just shy of 4,200. The Dow Jones Industrial Average is up 2% in April.

The mid-March chaos saw markets go “straight from banking crisis to recovery,” said Olivier d’Assier, head of applied research, Asia-Pacific, at Qontigo, a Deutsche Börse-owned global index provider, in a Tuesday note.

Investor sentiment, however, “took a detour, with fears of a banking crisis (unrealized losses, bank runs, insolvency, closures, tight liquidity), giving way to fears of an economic crisis (earnings drought, loan defaults, unemployment, debt burden, hard landing) first,” he wrote.

But the relentless rally is gaining some converts, and sentiment gauges are no longer deep in bearish territory. Sentiment is improving across markets, not just in the U.S.

“Investor sentiment has stopped falling and began to climb in all markets we follow, perhaps in a desperate attempt to bargain with the Rumpelstilskinesque of rising markets,” said d’Assier.

As for the sentiment measures highlighted by Essaye, they’ve all moved higher. The CNN Fear and Greed Index stood at 67 on Tuesday, back in “greed territory.” An AAII Bulls/Bears reading at -8.4% still signals a cautious attitude, but a more “neutral” stance, Essaye said, while a 24.4 reading on the Bulls/Bears ratio is closing in on the 30 level that tends to signal a pullback may be in the offing.

In other words, sentiment has seen a substantial improvement, though not to levels that indicate the pain trade is ready to flip toward falling stocks, Essaye said.

Meanwhile, earnings season is getting fully under way this week.

“For the next three weeks, Q1 2023 corporate earnings reports and, more importantly, forward guidance for the rest of the year, will help bridge the gap between the resilience of markets and the reticence of investors,” said Qontigo’s d’Assier.

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