Many have been confounded by the stock market’s surge since March 23rd amid less-than-rosy U.S. economic data. That disconnect narrowed on Thursday, as jitters about a potential second wave of COVID-19 infections—along with a grim economic outlook from the Federal Reserve—drove investors out of riskier assets and led to a 5.9% drop in the S&P 500® index.

Ongoing volatility underscores the precariousness of the recent rally. Even as the S&P 500 index rallied to recoup much of the losses made since its March 23rd low, we have cautioned that a second wave of coronavirus cases could upend investor confidence, raising the prospect of a fresh round of social-distancing restrictions or layoffs.

U.S. stocks and economy: Mixed signals

In recent weeks, the gap between economists’ estimates and actual May U.S. payroll gains caused Citi’s Economic Surprise Index to spike. The series, which measures data surprises relative to market expectations, has recovered from its deep plunge into negative territory, confirming that data in the past week have continued to come in better than anticipated—although remaining very weak in absolute terms.

The Citi Economic Surprise Index rose sharply recently


Source: Charles Schwab, Bloomberg, as of 6/10/2020.

The rub with the recent uptick is that the unexpectedly strong May jobs report—in which payrolls gained 2.5 million jobs and the unemployment rate declined to 13.3%—alone constituted most of the surge into positive territory. In other words, positive surprises reflected extremely low expectations, not a meaningful improvement in the growth rate of the economy. The hole from which the economy has to emerge—however narrow—is deep enough to suggest market-based enthusiasm about a sharp recovery may have been unfounded.

As U.S. stocks rallied off the March lows, measures of investor sentiment followed suit; with some behavioral measures showing signs of excessive optimism and even froth, and attitudinal measures starting to signal complacency.

As you can see in the chart below, Ned Davis Research’s Crowd Sentiment Poll—a reflection of various sentiment indicators—has emerged out of the “extreme pessimism” zone and, as of June 9th, climbed well into extreme optimism territory. Extremes were also seen in options trading (as per recent findings by SentimenTrader) and huge spikes in hyped-up bankruptcy stocks’ prices (as per Bloomberg).

We like to remind investors that sentiment at extremes doesn’t in and of itself suggest a near-term surge or pullback is imminent. Rather, it signals that stocks have become more vulnerable to negative catalysts, which could come in the form of downbeat economic- or virus-related developments—as was the case by Thursday.

Investor sentiment has moved into the “extreme optimism” zone


Source: Charles Schwab, ©Copyright 2020 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. See NDR Disclaimer at www.ndr.com/copyright.html. For data vendor disclaimers refer to www.ndr.com/vendorinfo/. Data as of 6/10/2020.