Touch of Grey: Sentiment is a Mixed Bag

by Liz Ann Sonders

June 30, 2014

Key Points

• An update on investors sentiment yields mixed messages
• Individuals are mildly optimistic; newsletter writers are wildly optimistic
• Offsets to elevated investor optimism are less-enthusiastic consumer confidence and the "don't fight the Fed" factor

The consensus of market watchers appears to be that a correction is overdue, thanks to a combination of seasonal/election cycle tendencies, the long span since the last correction, and elevated optimistic sentiment—a contrarian indicator. I’ve written a lot on the first of these; while today’s report will focus on the latter two, notably sentiment. It’s a chart-heavy, but text-light report, so don’t let the number of pages deter you.

It has been almost 1,000 days since the last decline of 10% or more. The current rally of over 78% represents the firth longest of all time, just behind the period from 1984 to 1987. But it's well shorter than the longest rally of all time, which was 233% from October 1990 through October 1997.

Sentiment mixed messages

First up is the poll of investors by the American Association of Individual Investors (AAII), and as you can see it's basically in the middle of the pack of readings over the span of the pre-and post-financial crisis period. In other words, we're not seeing an extreme of either bullishness or bearishness.

Based on a study by Bespoke Investment Group (BIG), one potential explanation for why bullish sentiment among individual investors is relatively low may be due to the fact that the Dow Jones Industrial Average (DJIA), the index that is most widely followed by Main Street investors, has been underperforming the S&P 500 by a wide margin. With a gain of less than 2% on the year, the DJIA is underperforming the S&P 500 by more than four percentage points. Of the 30 components in the index, 43% are down so far this year. That compares to the S&P 500 where only 27% of stocks in the index are down year-to-date. The good news is that breadth being stronger in the S&P 500 is important since it’s a broader representation of the stock market; so the DJIA’s weakness is less worrying.

Individual Investors Not Overly Bullish

Source: FactSet, as of June 27, 2014. AAII=American Association of Individual Investors.

Perhaps more telling is a longer-term chart of AAII's reading of bullishness, utilizing a 50-week moving average; this time tracked against the S&P 500. As you can clearly see in the chart below, bullishness has remained quite subdued during this strong bull market. It's an illustration of why this bull has often been termed the "Rodney Dangerfield Market" (it gets no respect); and why the well-known phrase, "bull markets like to climb a wall of worry" has been so apt during this bull market.

Bullishness Very Subdued Longer-Term

Source: FactSet, as of June 27, 2014. AAII=American Association of Individual Investors.

Next up is a reader favorite: SentimenTrader.com's (ST) "Smart Money/Dumb Money Confidence Survey." According to ST, you want to follow the Smart Money traders when they reach an extreme. Examples of Smart Money indicators include the OEX put/call and open interest ratios, commercial hedger positions in the equity index futures, and the current relationship between stocks and bonds. You want to do the opposite of what the Dumb Money is doing when they are at an extreme. Examples of Dumb Money indicators include the equity-only put/call ratio, the flow into and out of the Rydex series of index mutual funds, and small speculators in equity index futures contracts.

In practice, ST's Confidence Indexes rarely get below 30% or above 70%. Usually, they stay between 40% and 60%. When they move outside of those bands, it's time to pay attention. As you can see in the chart below, Smart Money is now below 30% and Dumb Money is above 70%.

Smart & Dumb Money Diverge to Extremes

Source: SentimenTrader.com, as of June 27, 2014.

There's another subset of investors—or perhaps better put, influencers—that have a sentiment index associated with them: investment newsletter writers. Investors Intelligence (II) devised this index and it's seen below.

Bullish sentiment is above 60% for the fourth straight week, something not seen in nearly 10 years. BIG looked at every streak since 1970 when II's bullish sentiment was above 60% for at least four weeks. The average subsequent three-month and six-month returns for the S&P 500 were not impressive.

Over the next three months, the S&P 500 averaged a respectable gain of 1.7% with positive returns 54% of the time. Six months later the returns were a paltry 0.8%, with positive returns less than half of the time. Based on these results, a near-term pullback may be in the cards.

Newsletter Writers Extremely Optimistic

Source: FactSet, as of June 20, 2014.

Switching gears, let's also look at other factors that may have kept the market afloat so far, even though many sentiment indicators have been displaying "frothiness" for some time. Measures of investor sentiment are generally good contrarian indicators at extremes; but lesser known is that consumer confidence (which doesn't necessarily relate to the stock market) is also a contrarian stock market indicator, especially at extremes, as you can see in the chart below.

As Ned Davis Research (NDR) recently pointed out, while stock pros have been generally quite bullish, consumers have been pessimistic or skeptical. "We've never had the kind of general social mood euphoria that we have typically seen at other peaks in investor sentiment."

Consumer Confidence Still Relatively Weak

Source: Conference Board, FactSet, Ned Davis Research, Inc., as of June 30, 2014.

NDR also notes the "don’t fight the Fed" factor. "Never in history has the Fed been as easy as it has been in this last cycle. By taking the yield on cash to nearly zero, the Fed has made investable assets look attractive relative to zero. And never has the Fed been as easy in terms of quantitative easing as it has been this cycle."

Yields on Cash Near Zero

Source: FactSet, as of June 30, 2014.

I learned a lot of what I know about sentiment from both Ned Davis and my first boss and mentor Marty Zweig (the two of them collaborated for much of Marty’s career). In fact, I’ll remind readers that Marty coined the phrase "don’t fight the Fed" and invented the Put/Call Ratio.

Ned likes to point out that one should "not overreact to the first signs of high optimism." Sentiment needs to be viewed with an appropriate lens. The net of my view is that sentiment is on the list of short-term worries; but in and of itself should not send investors into a panic that a correction is imminent.