January 7th, 2011

Investor Sentiment and Market Direction

One of the wonderful things about coming out of a bear market is that there always seems to be a lot of historical symmetry one can usually find.

I should first point out that contrarians, these days mostly economists who dare comment on the stock market’s outlook, seem to latch on to bullish investor sentiment as an indication that the market is overvalued and destined to decline. For example, two weeks ago Paul Lim wrote in the Sunday NY Times in an article entitled “Why Investor Optimism May Be a Red Flag“:

“…. investors are finally getting their risk appetites back. And it may also be an indication that people are becoming greedy after the easy money has already been made in the market…..some market strategists worry that investor optimism itself may be a headwind to another strong year for the market …. It just goes to show that by the time the market thoroughly convinces investors to be optimistic, most of the good news is already behind us.”

(Of course, the Times reversed themselves this week in a piece entitled “Can You Trust the Market?” where they repeated the statistic on the $80 billion investors withdrew from equity funds in 2010 with the following explanation: investors are leery of the market including two crashes in ten years, the “flash crash” and Republican efforts to stall further financial industry regulations.)

Does optimism lead to a decline or does optimism coincide with a strong market? Does pessimism lead to an advance or does pessimism coincide with a bear market? It’s truly a chicken/egg question. Rather than attributing a causal relationship between investor sentiment and the direction of the stock market, it is safe to say that they tend to move in tandem. When sentiment is optimistic the market advances and when sentiment is pessimistic the market declines.

Intuitively, though, the high bullish sentiment that contrarians fear seems to me to augur well for the market’s outlook. I didn’t have any evidence to support my belief until recently when the Bespoke Investment Group, the purveyor of a plethora of market statistics of all sorts, published a chart of investor sentiment over the past 10 years in a piece entitled “Bullish Sentiment: Down But Still Lofty”. Their statistic combines the level of bullish sentiment readings from the Investors Intelligence (II) and American Association of Individual Investors (AAII) surveys.

Rather than focusing on small changes in the level of this indicator, I compared the sentiment indicator against that S&P 500 over the same period and arrive at a decidedly different conclusion:

What struck me was the apparent symmetry in market sentiment between the early stage of the recovery out of the Tech Bubble Crash and the current bull market. The last time sentiment was this positive was from mid-2003 and the beginning of 2004. It wasn’t until the market began to consolidate did the sentiment indicator start become less optimistic. From the bottom of the Tech Crash in March 2003 to February 2004, sentiment fluctuated between 100 and 130.

The sentiment indicator hit 130 for the first time again this past August as the market began moving out of the 14-month trading range. If the previous recovery is any indication, the market could continue to rise and sentiment could continue to fluctuate at optimistic levels for several months before a correction sets in and the indicator begins to turn bearish.

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  • Anonymous

    Sp500 PO of 1590 by Summer. I predicted from tech analysis a Sp500 of 1295. I am revising since we are there the new PO. Also for steels I really like MTL w/ a PO of 62 for the Russina steel company. Where's JC (Jesse)? Expect he's hiding in the weeds with his PO of sub 900 on the SP500!??!?!?

  • Anonymous

    why MTL, not MT? aren't they should be acting the same?

  • Anonymous

    MT is a global steel company from Europe. MTL is a pure Russian ADR play with a higher PO percentage gain from here. MT is good too!

  • Anonymous

    Is there long term steel price chart?

  • Anonymous

    guru,

    would you a buyer of NBG (National Bank of Greece) now?

  • Joe

    I've been busy updating my Watchlist, please accept my apologies for not answering quicker:

    1) NBG isn't the sort of stock I would buy; it may bounce back but the stock hasn't indicated any attempt to reverse direction. I don't try to catch "falling knives".

    2) SLX is a steel ETF but I didn't bother to find out which stock make it up.

    3) MTL has broken above some long-term resistance at 29 but MT still has to go above 43.50 to confirm that an up-leg is sustainable.

    4) My stretch price target for towards the end of the year or beginning of 2012 is 1500-1550 (see Sweet Dreams.