Comfortably Numb: Have Investors Become Too Complacent?

Comfortably Numb: Have Investors Become Too Complacent?

April 2, 2012

Let's get right to the point: It was the best first quarter for the stock market since 1998. The total return of the S&P 500 index® was 12.6% for the quarter; up nearly 30% from the October 3, 2011 low. What was particularly notable about the surge since then has been the attendant plunge in volatility.

Complacency?

As you can see in the chart below, the CBOE Volatility Index (VIX) has dropped dramatically from its high of 48 last August (when Washington's fearless leaders failed to construct a debt deal, leading to Standard & Poor's downgrade of US debt) to 15 recently.

Plunging Volatility

Source: FactSet, as of March 30, 2012.

Many investors—notably those painfully on the sidelines—have suggested this shows a high level of complacency. And the fact that trading volume has been weak has been another pillar in the bears' case for why the "rally isn't for real." (See more on trading volume later in this report.)

Most readers know I have been optimistic, and remain so. But, the contrarian in me does have some sympathy for the case that optimism has become elevated enough to offer a headwind for the market in the near term.

I am a big fan of the sentiment work done by Ned Davis Research (NDR) and SentimenTrader.com. NDR noted recently in a report that the recent backup in Treasury yields has accompanied a rise in optimism by investors, and this combined indicator did flash a short-term sell signal for the market. That said, NDR argues, and I concur, that yields remain extremely low and as such, are not "biting" stocks yet.

Elevated optimism = near-term headwind

Below is NDR's most widely-followed sentiment measure, its Crowd Sentiment Poll, and as you can see, accompanying the market's rally has been a surge in optimism into the "uncomfortable" zone. Given a bit choppier action lately by stocks, I am hopeful we will see a waning of this optimism, at least back into the neutral zone.

Elevated Optimism

Source: FactSet, Ned Davis Research (NDR), Inc. (Further distribution prohibited without prior permission. Copyright 2012 © Ned Davis Research, Inc. All rights reserved.), as of March 27, 2012.

Another sentiment metric showing elevated optimism is SentimenTrader's Smart Money/Dumb Money Confidence index, shown below.

Smart Money Warming Up to Market

Source: FactSet, SentimenTrader.com, as of March 30, 2012.

Although no where near the recent extremes of smart money pessimism and dumb money optimism, it bears watching. The good news is that the gap has begun to narrow in a favorable way. Remember, as the labels suggest, the smart money tends to be right at extremes of sentiment, while the dumb money tends to be wrong.

Crash worries still abound

But not all sentiment metrics are created equal. One I discovered recently is put together by the folks at Yale and it measures the perceptions about the likelihood of a stock market crash among individual and institutional investors. I quibble with the way they pose the question, making the chart a little difficult to decipher, but let me explain. First, see the chart below:

Crash Likelihood Still Seen as High

Source: FactSet, Yale School of Management/International Center for Finance, as of February 28, 2012.

The question is asked in a way that the reading expresses the percentage of survey respondents that believe a crash will not occur. In other words, as per the latest readings, less than 25% of the survey's respondents, either individual or institutional, believe the market won't suffer a crash. Put another way, more than 75% believe there's a high likelihood of a crash. This is a clear sign that the "wall of worry" the stock market likes to climb is still very much intact.

Investors loving bonds

Much of what I've highlighted above are sentiment measures of attitudes, not actions. One clear way to judge the latter is to look at mutual fund flows. Given that the past five years have seen a record $1.3 trillion spread in favor of bonds over stocks, I agree with the notion that investors have yet to become overly enthused by stocks.

All About Bonds

Source: FactSet, Investment Company Institute, as of February 28, 2012.

I also think fund flows help explain why trading volume has been so low. Simply, the retail investor has not been engaged with this market rally and much money has remained on the sidelines. Add to that the fact that high-frequency traders (HFT), which accounted for over 70% of last year's trading volume at times, are under a magnifying glass held by the Securities and Exchange Commission (SEC) for questionable trading practices. This has likely kept many of the HFTs in hibernation.

Businesses happy; consumers less so

Let me step off the market path for a moment and share another interesting sentiment analysis. Last Wednesday, the Business Roundtable recently released its first quarter CEO Economic Outlook Survey, preceded the day before by the release of the Conference Board's measure of consumer confidence. CEOs are now as optimistic as they were during much of the pre-recession period. Although they cite headwinds including Europe, China, oil prices and US political uncertainty, they do not believe they will materially impact their business.

On the other hand, consumer confidence pulled back from a still-weak reading in the latest report. It had risen sharply in February. The level of confidence, with a headline of 70, is well below where the index stood during prior economic expansions.

For what it's worth, CEO confidence has historically acted in a similar manner as the aforementioned "smart money" and its high level of confidence is comforting. On the other hand, very weak periods of consumer confidence have typically been accompanied by higher stock market gains, as the consumer has historically acted in a similar manner as the aforementioned "dumb money."

Schwab's survey says

Finally, we have a new survey from Schwab of its active traders. The latest Charles Schwab Active Trader Sentiment Survey polled 421 individual investors who trade frequently and found 51% now consider themselves bullish—the highest level since we began tracking active trader sentiment in April 2008. This is up from only 25% in October 2011. Only 14% say they are currently bearish.

In sum, my optimism in the medium-to-long-term has not been dented by the latest sentiment readings. Last week was the 26th consecutive week of better-than-expected economic news. Of the 17 indicators that ISI tracks that did a good job tracking 2010 and 2011 double-dip recession concerns, only two are presently weakening, with First Call's earnings revision index notably strong. However, I do think the market has become more vulnerable to negative news in the short term.

Important Disclosures