STOCKMARKET SENTIMENT CAN PROVIDE AN ADVANCE WARNING SYSTEM
Many market analysts would have us believe that Stockmarkets are primed for another bumper year in 2014. Such claims are backed up with data to support their theory, much of which is compelling.
Yet little is mentioned of current Stockmarket sentiment which would imply that a Stockmarket correction in the near future seems a reasonable assumption given that there is excessive optimism, particularly amongst the financial media and investing public. Unfortunately these groups are known to be notoriously bad at Stockmarket timing. Historically such euphoria amongst these groups usually precedes a fall. Not wishing to be a party pooper or a bearer of bad tidings it seems to us that few investors are taking note of the Stockmarket sentiment readings. That could be a mistake.
Current Stockmarket Sentiment Readings
In our weekly research we record and analyse twelve Stockmarket sentiment readings the data for which is published each week through our website. Rather than list all of these we show six to highlight our concern that Stockmarkets could be becoming over heated.
1. The VIX Indicator
Often referred to as the “Fear Gauge” this indicator is used to measure “Implied Volatility” via the pricing of Index Options traded in the Stockmarket. Specifically, the index is used to forecast future volatility in the months ahead.
In a Contrarian sense implied volatility will be very low at “Market Tops” and extremely high after a sharp fall. Logically this makes sense when one understands that at the top of the market, just before a correction, there is little fear.
The VIX Indicator has been very low. It has just gone lower still.
2. Our Bull/Bear Ratio
We created this index by dividing the amount of money invested by US Private Investors in “Bull funds” which will profit if Stockmarkets rise, by the amount of money invested by US Private Investors in “Bear funds” which will profit if markets fall.
This ratio usefully provides a measure of Private Investor sentiment. If the ratio is very high this would mean most investors have moved money into “Bull Funds” and hold very little money in “Bear Funds” hence they expect Stockmarkets will rise.
The problem this creates for the Stockmarket is that if the majority of Private money has invested hoping that markets will rise, this also means that there are few investors left to buy into the market. If all the money is invested, who is left to create further liquidity if no one wants to sell?
Looking back over many years of data we have found this indicator records extremely high readings just before the market suffers a correction.
Last week our Bull/Bear Ratio recorded the highest reading we have seen in the last 2 years on the 2nd December. Whilst the ratio may still go higher we would advise caution.
3. Our Money Market Ratio
We created another indicator to measure the way in which private investors would typically transfer their holdings into Money Market funds when they fear Stockmarkets will fall and conversely would transfer their holdings out of Money Market funds when they expect Stockmarkets to rise.
Much like a mirror image of the Bull/Bear Ratio the Money Market Ratio will be extremely low near a Market Top as private investors increasingly move more money out of these funds.
We have again found this indicator to be extremely useful at recording very low readings as we approach market tops. The reverse is also true. We have found that most private investors will pile into the market at the top and will eventually capitulate, after suffering heavy losses, electing to move their holdings back into the Money Market near the bottom of the Stockmarket cycle.
In summary, when our Money Market Ratio is extremely low a Market Top is usually close. In contrast, when our Money Market Ratio is extremely high we have probably seen or are close to a Market Low.
We recorded very low readings last week on this indicator. Whilst not extreme, they are nonetheless sufficiently low to cause some concern.
4. Investment Media
We record data on weekly surveys of the numerous articles by investment journalists where opinions as to the direction of the Stockmarkets can be recorded. High readings will appear when the majority of financial journalists advocate Stockmarket investments and vice versa.
This is another useful measure of Stockmarket sentiment. Thoughts of the “Herd Instinct” come to mind. Our conclusion is that financial journalists and investment newsletter writers are notoriously bad at Stockmarket timing.
If Stockmarkets are doing well and everyone is happy the media will feed the euphoric frenzy. It follows that excessively high readings do not necessarily bode well and could indicate we are in the Euphoria stage.
This indicator just hit the highest weekly reading in three years. Of course the readings may go higher, but given the performance of the markets over the last 3 years don’t be surprised if we see a turn sometime soon.
5. Investment Advisors
Similar to the Investment Media, we record the weekly data on Opinion Polls taken from Investment Advisors as to their outlook regarding the Stockmarket. The inference being that this should feed through to their recommendations to clients.
Unfortunately, like the Investment Media, their opinions are often be wrong. Particularly when extreme readings are recorded. Again herd instinct and euphoria are in play here.
Readings last week, whilst high, were not extreme, coming in at just over 80% of our three year range.
6. Fund Managers Equity Proportion
This indicator measures the aggregate percentage that US Fund Managers hold in the Stockmarket within the Investment Funds that they manage.
The interpretation for this indicator is similar to the way in which we interpret the Bull/Bear ratio. In recent weeks the average equity content for US Fund Managers has been as high as 97%. This is an extreme reading. This would imply that there is very little further capacity.
SUMMARY
We could use an analogy to explain how Stockmarket Sentiment can be used to provide an advance warning. Imagine you are driving a car. Many of these indicators could be viewed like the fuel gauge. The key point being that the fuel which drives the engine is the pool of available new money which could come into the market. If the majority of that money is already invested then the fuel gauge is running on the reserve tank.
Earlier we explained that we record and analyse twelve separate indicators on a weekly basis so that we can provide our readers with a useful guide on how to interpret current Stockmarket sentiment. This is freely available through our website and the link is shown below.
Whilst we believe such data has value we would advise against using it in isolation. We would recommend using Stockmarket Sentiment analysis to support a multi-faceted approach towards research across all markets to aid and improve your investment decision process.
If this article is of interest please view our sentiment research each week.