Investor Sentiment

Our behavioral model continues higher and has moved into a traditionally complacent area that may indicate a slight pause or even a pull-back from these lofty levels. The S&P 500 has gone on to return close to 14% from our October 12th buy signal. Our stock portfolio has done quite well for January, up over 15%, and is up even more in February so we’ve taken partial profits last week and have locked in gains for the year.

Volume and pricing action was mixed this week and, in our opinion warranted moderate profit taking. On Tuesday, the market showed signs of resiliency after bouncing back from early losses on news that a Greek bailout was close to finalization. Volume was up slightly after the late day rally and the S&P 500 finished above the key 1350 level. Wednesday and Thursday offered less encouraging pricing and volume action. On Wednesday, the market sold off aggressively from early gains on higher volume. On Thursday the market rallied strongly on less than stellar volume. Our belief as contrarian thinkers is that the market may push to higher levels as individual investors (typically late to the game) start to move money back into the market. Based on the tone of the mood we have been seeing, it would appear this is the case.

“After several months of relative calm in Europe and an uptick in the U.S. economy, investors just emerging from their bunkers are realizing that the rally train might have left the station already. The dilemma for those who sat out the U.S. stock market's recent climb: Should they jump into an upswing that could quickly evaporate, or risk missing out on further gains?” Tom Lauricella and Jonathan Cheng – Wall Street Journal – 2/13/12.

“Long-term mutual funds had estimated net buying of $13.17 billion for the fifth consecutive week as investors’ added money across the board, according to the Investment Company Institute. In 2011, investors pulled money from stocks for most of the year, but bond and hybrid funds mostly had inflows.” Nathalie Tadena – Wall Street Journal – 2/16/12.

Bottom Line: Renewed interest on the part of “unsophisticated money” is usually a negative sign for the market.

AAII Investor Sentiment

One item we tend to track in the American Association of Individual Investors (AAII) Sentiment Survey. Taken from their web-site, “The AAII Investor Sentiment Survey measures the percentage of individual investors who are bullish, bearish, and neutral on the stock market for the next six months; individuals are polled from the ranks of the AAII membership on a weekly basis. Only one vote per member is accepted in each weekly voting period.”

While we do not incorporate this model into our behavioral calculations, we track the results for certain anomalies. This survey has been used in the past as a contrarian indicator.

“Investor sentiment measures have historically been used as contrarian indicators—meaning one would expect the market to do the opposite of what the data was saying. The analysis here appears to support that point.

While little may be gleaned from changes in investor sentiment, identifying extreme levels of positive or negative sentiment appears to offer a glimpse of where the markets may be headed. In looking at the AAII Member Sentiment survey, we found that when sentiment reached overly bullish levels, the markets normally responded negatively in the months that followed. Conversely, the market tended to rise when members became overly bearish.

While our results here seem to lend validity to the notion that investor sentiment may be used as a contrarian indicator, it would not be wise to base all your investment decisions upon it. Indicators such as this are best used in tandem with others so that you receive confirming signals of potential market movements. Sentiment merely serves as an additional tool when making investment decisions.

Lastly, even if you do not use sentiment data as an indicator, it is a good idea to be mindful of it. As investors become overly bullish or overly bearish, it is easy to get caught up in the herd mentality.

However, as we have shown, if you run with the herd, you might get trampled.” - Wayne A. Thorp, CFA, associate editor of Computerized Investing and AAII’s financial analyst.

Last week, the survey produced 42.7% of respondents saying they are “bullish” towards the market and only 26.6% claimed to be “bearish. These results are at extreme levels and have been for the past seven weeks. Since the start of the year, investors responding to the AAII survey have been overly bullish as the percent of bullish responders has remained above 40% while those that claim to be bearish have hovered near 20%. We use a ratio of bullish to bearish respondents to attempt to capture an increasing sense of bullishness. Figure 2 shows that ratio has been above 2-to-1 for five of the last seven weeks.

Bottom Line: Our behavioral model is approaching levels that coincide with near-term market sluggishness and the general tone of the market indicates individual investors are just now starting to buy into the rally. As a contrarian investor, these are indications to keep our bullish stance in place but take some profits off the table.

Joseph S. Kalinowski, CFA