Sentiment Indicators are a Bit Out of Whack

Anyone who takes the study of the stock market seriously undoubtedly spends at least some of their time with sentiment indicators. For example, sentiment models and indicators account for 15% of our daily risk management work and 10% of our weekly work. So, while market sentiment is obviously not nearly as important as trend, momentum, breadth, or fundamental indicators, it is something to pay attention to – especially when the mood of the market reaches an extreme.

It is said that the public is always wrong at market turns and that it often pays to go the opposite of what the public is doing. The thinking here is that by the time the investing public is really feeling good (or bad) about the stock market, the majority of the move has already occurred. As such, there are those that love to invest in a “contrary” manner to whatever the prevailing sentiment is at the time. However this is really a misnomer as it is important to recognize that the public is always “right” during the middle of trends. It is only at important turns that the majority are left behind fighting the last war.

The reason it pays to look at sentiment – especially when extremes are reached – is very simple. By the time everyone you know can tell you why something is happening in the stock market, they’ve likely already adjusted their portfolio to reflect their view. In other words, once “the crowd” becomes bullish on stocks it likely means that all the money that wants to be invested has already been invested. As such, the market becomes susceptible to a swift decline once a “trigger” comes along – because the money available to go into stocks has already been spent.

I’d like to make two points on the topic of investor sentiment this morning. The first is that the sentiment indicators are a little nutty right now. After a rally that has lasted 25 days (five weeks), one might expect to see the sentiment indicators starting to show too much optimism (which is an indication that the buying power may be close to being used up). And while I have certainly witnessed some exceptional giddiness on the part of the mutual fund types on CNBC lately, my sentiment indicators are only neutral.

Of the five sentiment models we use in our daily risk management model, two currently carry maximum negative readings, two are neutral, and one is actually positive. This, after a 25-day run for the roses with only two modestly bad days. Trust me when I say this is a little strange because usually, all five sentiment models would be sporting minus signs right about now.

Perhaps this is due to the fact that short-term and long-term sentiment is diametrically opposed at the present time. Clearly there is a little too much happiness seen in the current joyride to the upside. As such, the shorter-term sentiment indicators are flashing warning signs. However, from a longer-term perspective, the negativity toward the macro view is so thick you can cut it with a knife.

For example, do you know anyone, anywhere that thinks the economies of the U.S. and Europe are going to be good any time soon? Do you know anyone that is upbeat about the jobs market or housing or the fate of the Euro? Yep, that’s right; the global macro view is pretty ugly right about now.

My first primary point this fine Friday morning is that the sentiment indicators are a bit out of whack at the present time and it might be a good idea to view them accordingly.

The second issue I’d like to address this morning on the always challenging issue of investor sentiment is that there just might be too many eyeballs on the subject. Think about it; if everyone in the business is watching the same (or at least similar) sentiment indicators, and everyone is looking for those extreme levels, do the indicators have as much value as they did when fewer people were paying attention?

In other words, isn’t it tough to go contrary to the crowd when the crowd itself is looking to be contrary? I’m just saying…

Turning to this morning… Stocks in the U.S. are pointing to a modestly lower open after the Q4 GDP report came in below expectations.

On the Economic front… The government’s advance report on the nation’s fourth quarter GDP shows the economy grew at a rate of +2.8% during the October-December period, which was below the consensus expectations for an increase of +3.1%.

David Moenning
Editor:  The Daily Decision