A sizable correction in the stock market is not imminent despite stretched positioning, Goldman Sachs says

  • A surge in bullish investor sentiment is not enough to derail the stock market's recent rally and deliver a sizable correction, according to a Wednesday note from Goldman Sachs.
  • Positive COVID-19 vaccine news in November helped stage a strong rally in stocks and led to investors piling into the market, staging a risk-on mode for the markets.
  • But while sentiment indicators can be powerful contrarian signals when at stretched bearish levels, they are mixed when at extreme bullish levels, according to Goldman.
  • "The strong pick-up in positioning indicators suggests more moderate risky asset returns are likely from here, rather than an imminent risk of a sizable correction," Goldman said.
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Investor sentiment has turned extremely bullish over the past month as positive COVID-19 vaccine news helped drive a risk-on environment for the stock market.

The promise of a return to normal in the coming months as mass vaccinations begin has led to stretched investor positioning based off a number of indicators, Goldman Sachs highlighted in a note on Wednesday. 

Four of the 13 sentiment indicators tracked by the investment bank are at their 5th percentile level (top bullish level), with none of them near the bottom percentile (top bearish level)

But despite the stretched positioning, a sizable correction in the stock market is not imminent, Goldman said. Instead, investors should expect more moderate returns for risky assets going forward.

"The strong pick-up in positioning indicators suggests more moderate risky asset returns are likely from here, rather than an imminent risk of a sizable correction," Goldman explained.

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The main reason behind Goldman's analysis is that while investor sentiment indicators can serve as powerful contrarian signals, that's mostly true when sentiment is at stretched bearish levels, not bullish levels.

"We have found that bullish positioning levels tend to remain strong for a long period if macro remains supportive," Goldman said.

The macro backdrop for stocks hasn't looked better for sometime, according to JPMorgan, as the economy is set up for a rapid recovery as the COVID-19 virus becomes less of a risk due to the rollout of vaccines. 

As Goldman expects risky asset returns to moderate from here, the firm recommends investors juice returns by selling options, given that equity volatility "continues to look expensive compared to the recovery in risky assets," the note said.

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