One area I watch constantly is the sentiment of the market. On an individual basis, many investors can make profitable and timely market calls. And, some do it consistently.
However, as a group, human beings are terrible at market forecasting. I suspect this is because we feel more comfortable going with the crowd and doing what others are doing rather than being an outsider with a variant perception of the market.
As a result, I like to bet against the crowd… and currently, the crowd is too bullish.
This first chart is a survey from the National Association of Active Investment Managers. Each week, these active managers are asked to prove their overall equity exposure to the markets. As the chart illustrates, the allocations are still more than 80%, which is too optimistic. In fact, while this level occurs approximately 1/3 of the time, the annualized returns are negative 1%.
It’s unlikely that you’ve seen this chart before. So, as a fun exercise, it’s worth looking at market extremes to see how the crowd behaves. At the bottom of the recent meltdown last October, 2014 active investors were less than 15% allocated to stocks.
At the bottom of the European crisis in 2011, active managers were not allocating to equities. The same can be said for the bottom in March 2009. By that time, they had withdrawn exposure at the exact point that was a generational buying opportunity in stocks!
Conversely, at the highs of 2007 and 2008, the crowd was overexposed to equity markets, right before they fell sharply and erased many years’ worth of gains. There are times when the crowd gets it right but the extremes are often at key market turning points.
Sentiment will have to fall sharply before I’d get aggressive in buying stocks again.
The second chart shows the composite sentiment among a group of indicators including individual investors, financial advisors, asset flows into market timing mutual funds, and other investors and traders.
Sentiment is starting to fall, which is good. At a current level of 60.5%, it’s inching its way down from an overly optimistic level (it fell five points in one week).
It’s worth pointing out that the recent high of 73.3 was the second highest level in the last 15 years. In fact, this analysis has been conducted since 1984, and it’s shown that it’s never been profitable to own stocks when sentiment is 70% until the indicator has fallen to the lower threshold.
That’s when the weak hands in the market have been completely wiped out.
So, while sentiment is becoming less bullish (a good thing for wanting to allocate stocks) it still needs to slide further before getting constructive on equities. In fact, it’ll have to drop below the lower boundary of 55 and likely much lower until one should get very bullish.
What could cause sentiment to fall further?
Well, we’re in the midst of earnings season. This alone will cause volatility in the markets.
Oil prices remain volatile and in a downtrend. Quantitative easing is cranking again in Europe. Negative surprises in these areas could certainly give investors pause.
Once the crowd has had enough, it’ll be time to jump back in. Even if for just an intermediate-term trade.