Goldman Sounds the Alarm on Stocks: When Euphoria Is This High, ‘It’s a Good Time to Reduce Risk’

The comments below are an edited and abridged synopsis of an article by Tyler Durden

The past few months have seen unprecedented market optimism and sheer euphoria. But the euphoria was bounded by the upper limit reached during the buying spree of the dot-com bubble, and the first week of 2021 was off the charts. Recently, Citi’s latest panic/euphoria model hit a record reading of 1.83 versus an upwardly revised 1.69.

Goldman Sounds the Alarm on Stocks: When Euphoria Is This High, ‘It's a Good Time to Reduce Risk’ | BullionBuzz | Nick's Top Six
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What does this mean? According to Citi chief economist Tobias Levkovich, there is now a 100% historical probability of down markets in the next 12 months.

Judging by market reaction, Levkovich may be right, and the selloff is just starting. Then again, the market has a tendency to do the opposite of what consensus expects it to do.

Goldman’s Risk Appetite Indicator (RAI) reached a reading of 1 last week—the highest in 4 years and just shy of an all-time high—after a large increase in risk appetite since Q4 last year.

Durden discusses monetary policy remaining supportive; a bullish shift in other sentiment and positioning indicators; RAI levels and the asymmetry to add risk; and the market’s vulnerability to negative growth or rate shocks.

Goldman isn’t telling its clients to sell just yet because, it says, risk appetite can stay at elevated levels for prolonged periods as long as the macro backdrop remains supportive.

On the other hand, “periods when the RAI declined back to zero from elevated levels have on average delivered positive, albeit slower, returns for risky assets.”

This is why the bank remains pro-risk in its asset allocation, and expects the S&P to rise to 4,100 by the end of the year, and 4,400 in two years. This is odd, because Goldman also warns that a backtest of extreme RAI readings is a good contrarian signal.

While the right move may be to sell, the question is when. As Goldman explains, market timing with the RAI alone is difficult. Still, what is coming won’t be pleasant: “…when the RAI is above 0.9 and until it normalizes below 0.75, it has been a good time reduce risk tactically.”

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