There are four main indicators or data sets advisors should evaluate and compare prior to making investment decisions on behalf of their clients:
- Market sentiment
- Market health
- Economic health
- Valuation
By weighing these indicators and comparing them to their historic counterparts, an advisor can assess whether the probability of a significant market decline is lower or higher than normal.
Market Sentiment
A fundamental difference between average and sophisticated investors is the ability to measure their competitors in capital markets. Measuring market sentiment involves assessing how competitors view the future and how those feelings translate into what they are doing with their money. Are they fearful? Are they overconfident? Are they greedy? Do their attitudes reflect sheep fearfully awaiting a shearing, cattle being mindlessly forced through a chute, or wolverines looking for their next prey?
While retail investors are watching television or listening to podcasts to gain investment cues, savvy advisors are measuring and analyzing their sentiments—as well as those of professional institutional investors—to gain a competitive advantage.
Market Health
Technical analysis allows investors to measure market health by observing price movements within the market. While technical analysis of the market does not always result in a conclusive diagnosis, it can provide an overview as well as gauge activity in stocks, commodities, futures, and any tradable instrument where the price is influenced by human behavior. One of the main aspects of technical analysis is understanding markets are not random; there are recognizable patterns that develop in response to important events. Prices react to the laws of supply and demand, that is, buying and selling pressure. But prices also have a memory, partially the result of support and resistance levels within a trading range.
Economic Health
The primary factors in evaluating economic health include monetary policy, market liquidity, inflation, and the bond market.
- Monetary policy refers to the Fed’s activities influencing the quantity of money and credit in an economy. Fiscal policy refers to the government’s decisions about taxation and spending. Both affect economic activity over time, either to accelerate or moderate growth and activity.1
- Market liquidity is an important factor because it directly affects investment returns and related costs for both private and public sector borrowers. Illiquid markets tend to be more volatile and at the extreme, can trigger or exacerbate financial crises.
- Inflation, the overall increase in the prices of goods or services, causes an erosion of the purchasing power of the dollar. Over time, the devaluation can be dramatic. There are many reasons for inflationary increases, including lower interest rates, wage increases, supply chain issues, and global economic problems. A classic example was the government stepping in to create liquidity via a huge infusion of capital in response to the COVID pandemic. There are various indicators that measure inflation, including the producer and consumer price indices, the ISM manufacturing index, and commodity prices.
- The bond market factor refers to bond interest rate spreads illustrated by the yield curve—a line that plots the yields of bonds having equal credit quality but different maturity dates. The slope of the yield curve suggests future interest rate changes and economic activity.
- In a normal yield curve, short-term debt instruments provide lower yields than long-term debt instruments of the same credit quality due to the time horizon and investor risk perceptions. An upward sloping yield predicts higher interest rates whereas a downward sloping yield curve indicates lower interest rates.2
- An inverted yield curve occurs when shorter-duration bond yields are higher than the yields on longer-duration bonds, an atypical situation that often signals an impending recession.3 When a yield curve inverts, it’s usually because investors lack confidence in the near-term economy and perceive the near term as riskier than the future, so demand a higher yield for a short-term investment than for a long-term one.4
The Valuation Factor
Valuation factors are a really big deal. They explain more than 80% of portfolio return variance over a 10-year period. When the market is highly priced, the probability of decline caused by lofty valuations is dramatically increased, whereas the likelihood of a large decline is extremely low when valuations are cheap.
The longer the investment horizon, the more important valuation factors become. In the short run, all the other indicators play a role in explaining the variability and profitability of a portfolio. Over the long run, however, valuation factors are the most meaningful because while the price paid for an investment does not change, other factors are cyclical.
Reviewing Surveys
When making investment decisions, the goal is to be buying into a crowd that’s fearful of taking risks and selling into a greedy crowd focused on a collective belief rather than value. The last thing we want to do is to sell our productive businesses (stocks) when there is panic in the market.
Much like the top echelon of NFL organizations that consistently make the playoffs by compiling better analytics than their competitors, the sentiments and actions of your investment competitors must be consistently measured. That information is then used to outperform, sometimes using a contrarian approach.
One of the most useful market sentiment factors to evaluate are surveys. For decades, surveys among both retail and professional investment audiences have asked the identical set of questions. The responses to these questions provide a tremendous amount of information as to what competitors think about the current and forthcoming investment environment. Most importantly, the survey responses reveal how their current views differ from historical survey norms.
Here are some of the surveys we review:
Consumers
The Consumer Confidence Survey® reflects prevailing business conditions and likely developments for the months ahead. Published monthly, it details consumer attitudes, buying intentions, vacation plans and expectations for inflation, stock prices and interest rates.5
The Survey of Consumer Expectations is a monthly survey of U.S. households by the New York Federal Reserve Bank. Consumers are asked how much they expect to spend, how high they expect inflation to be, their employment situation, and whether they are searching for a job. Roughly 4,500 consumers have been surveyed each year since 2013. Survey results are calibrated to be demographically representative of U.S. households.6
The International Center for Finance at Yale University publishes United States Stock Market Confidence Indices, including the One-Year Confidence Index, which measures the percent of the population expecting an increase in the Dow in the coming year. The Crash Confidence Index measures the percent of the population who attach little probability to a stock market crash in the next six months. The Buy-on-Dips Confidence Index reflects the percent of the population expecting a rebound the next day should the market ever drop 3% in one day.7
The U.S. Index of Consumer Sentiment (ICS) is provided by the University of Michigan. The index rates the relative level of current and future economic conditions, compiled from a survey of around 5,000 consumers. A higher-than-expected reading indicates a bullish consumer sentiment, while a lower-than-expected reading portends a bearish sentiment. The surveys have long stressed the important influence of consumer spending and saving decisions in determining the course of the national economy.8
The American Association of Individual Investors Sentiment Survey measures the percentage of individual investors who are bullish, bearish, or neutral on the stock market over the next six months.9
The International Stock Exchange Sentiment Indicator (ISE) measures investor sentiment by comparing the number of opening long call options to opening long put options purchased on the International Stock Exchange. The measure only considers purchases made by retail customers, thought by some to be the best measure of market sentiment. Purchases made by market makers or institutional clients are not included.10
If these surveys indicate consumers intend to spend more money, it’s a positive sign. As an investor, you want to have neutral or above average amounts of risk in your portfolio. When surveyed investors expect to spend more money because prices are going up and they feel they have to get ahead of future price increases, that sentiment accelerates economic activity and portends a healthy consumer environment.
On the other hand, if consumers are postponing purchases because of a deflationary environment, believing prices will go down and they will be better off waiting to spend money, that is generally a toxic environment in which to be taking higher than normal amounts of risk.
Financial Professionals
The Market Vane Bullish Consensus® measures the futures market sentiment each day by following the trading recommendations of commodity trading advisors. Trader sentiment determines the price directions of markets. If enough traders are bullish, regardless of the reason, prices will rise. Historical data from Bullish Consensus is available as far back as 1969, which makes it especially valuable for comparative historical analysis.11
The Chartcraft Investors Intelligence Sentiment Index seeks to ascertain the balance of power between the bulls and bears based on the opinions of 100 or more of the most widely read market newsletters whose writers issue independent advice and commentary.12 This is a highly reliable contrarian indicator for market tops and bottoms. When we see an unusually high ratio of one to the other, it’s an indication the markets are going to start moving in the opposite direction. When the vast majority are writing bullish articles, it’s likely the market is approaching its top. When the opposite occurs and the ratio of bearish to bullish articles is high, it’s even more apt that the market is about to bottom out.
The Consensus® Bullish Sentiment Index, published weekly, is a contrarian sentiment index for 32 major markets, including stocks indices, financial instruments, currencies, metals, energy, agriculture, and others. Contrarian opinion holds that when a predominant number of market analysts are bullish, it’s likely the market is approaching an overbought condition and a reversal is imminent. When a similar number of analysts are bearish, the market is apt to be approaching an oversold condition.13
The National Association of Active Investment Managers Exposure Index is a weekly summary of equity positioning of active investment managers, another contrarian indicator. A high net long position is bearish for stocks because these investors have already gone long during the uptrend, whereas short net exposure may be bullish because it can force traders to chase a bullish reversal by the market.14
Analysis
Because the data tracks trends among every market participant sector from Joe the retail investor to hedge funds, we gain a unique perspective of the market’s representative sentiment. When survey responses differ substantially from the historical norm, it’s a sign the approaching investment environment is either more fearful or greedier than is normal. That’s the value of having responses to the identical questions over a significant period of time. The historical comparison of responses forms a database of reliable information on which to base investment decisions.
While we understand survey responses may be right or wrong, what we are measuring is not the accuracy of the responses but rather the variance between what people are feeling today versus how they were feeling in previous surveys. So while the responses reflect an accurate representation of their current feelings, if people are basing their investment decisions on those feelings and outlooks, it often leads to poor performance.
If, for example, investors are worried, we would typically see a confirmation of that fearfulness reflected in high cash balances in 401(k) plans and do-it-yourself investment accounts. We would also likely see large purchases of gold and Treasuries, and high demand for put options within the market.
And while the financial markets would likely reflect current thinking, it doesn’t mean that thinking represents the optimal way to invest at the time. It’s more of a contrarian factor. The further away from normal the survey responses get, the higher the probability of having a regression back to normal. I believe isolating and investing on these variables alone should result in an investor outperforming the benchmark over long periods of time.
References
2 corporatefinanceinstitute.com
3 Kimberly Amadeo, “”Inverted Yield Curve and Why It predicts a Recession,” the balance.com, 23 May 2021.
4 Federal Reserve Bank of St. Louis. “Should We Fear the Inverted Yield Curve?” 8 Feb 2021.
5 http://www.conference-board.org/data/datadetail.cfm?dataid=consumerconf
7 https://som.yale.edu/centers/international-center-for-finance/data/stock-market-confidence-indices
8 http://www.wikipedia.org/wiki/University_of_Michigan_Consumer_Sentiment_Index
9 http://www.aaii.com/sentimentsurvey
10 James Chen, “ISEE Sentiment Indicator: What It is, How It Works,” investopedia.com
11 Tim Smith, “What is Market Sentiment?” investopedia.com
14 https://naaim.org/programs/naaim-exposure-index/
Ryan Zabrowski, author of the book Time Ahead, is senior portfolio manager at Krilogy based in St. Louis. He can be reached at rzabrowski@krilogy.com.
Krilogy Financial, LLC (Krilogy) is a Securities and Exchange Commission (“SEC”) Registered Investment Advisor. Registration with the SEC should not be considered an express or implied approval of Krilogy by the SEC. Krilogy does not provide tax and legal advice. All expressions of opinion are subject to change. This information is distributed for educational purposes only, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services. Investments involve risk and unless otherwise stated, are not guaranteed. Investors should understand the risks involved of owning investments, including interest rate risk, credit risk and market risk. Be sure to first consult with a qualified financial advisor and/or tax professional before implementing any strategies discussed herein.