Gauging Market Sentiment: Selling Greed Is Harder Than Buying Fear
A lot changes in a year.
Twelve months ago, stocks welcomed 2016 with a double-digit decline. Fears of recession took hold as oil spiraled downward to $26 per barrel and the specter of deflationary collapse gripped the market.
There is a common Wall Street adage about investor psychology: “Nothing changes sentiment quite like price,” and many sentiment measures registered levels unseen since the financial crisis.
For example, the Sentiment Survey of the American Association of Individual Investors (AAII) indicated that there were fewer bulls in February 2016 than in March 2009. Bank of America Merrill Lynch’s December 2016 Global Fund Manager Survey showed 15-year highs in cash balances and seven-year lows in equity allocations.
Enter a second common Wall Street maxim: “The stock market has called nine of the last five recessions.”
Contrarian investors who took note of these indicators and summarily bought the dip were rewarded. Similar contra-indicators have played out throughout history. The most notable? BusinessWeek’s “The Death of Equities” cover in 1979 — right before a secular bull market.
A third and final saying applies — this one from Warren Buffett: “Be fearful when others are greedy, and be greedy when others are fearful.”
What insight can these historical precedents and investing aphorisms offer in the current investment environment? Where does sentiment stand today? And how do we apply sentiment and crowd psychology to make informed, intelligent investment decisions?
A year after recessionistas were proven wrong in February, many of these sentiment measures have inflected higher. President Donald Trump’s election seems to have marked the return of “animal spirits.” A recent Investors Intelligence Sentiment Report registered 65% bulls — not an extreme reading, but above the roughly 45% average. CNN’s Fear and Greed Index scored in the high 60s — again not extreme, but above the mean.
We aren’t quite at 2000–2001 levels when cab drivers were pitching their favorite tech investments, but we are approaching the point when contrarians begin to straighten their posture.
How do we interpret this data? The answer, of course, is subjective.
None of these measures are reliable on their own. Is 65% bulls the time to sell, or is 70%? What about 75%? What these various sentiment measures are trying to do is quantify an inherently unquantifiable factor.
Crowd psychology doesn’t show up on an income statement, nor can it be translated into a P/E ratio. Like all other market-timing techniques, sentiment is not bulletproof. It relies on the supply/demand assumption that if everyone is bullish, no one is left to buy, and vice versa.
This isn’t to say that psychology can be ignored. It does play a critical role in investing. Seth Klarman said it best:
“Investing is the intersection of economics and psychology. . . . The economics — the valuation of the business — is not that hard. The psychology — how much do you buy, do you buy it at this price, do you wait for a lower price, what do you do when it looks like the world might end — those things are harder. Knowing whether you stand there, buy more, or something legitimately has gone wrong and you need to sell, those are harder things. That you learn with experience.”
Investors should not base their decisions on psychology alone, but they should always be assembling and updating their worldview. Paying attention to excessive sentiment is a good way to avoid overpaying.
For truly long-term investors — individual investors or those managing money who are blessed with great limited partners — the best advice may be to ignore sentiment completely. As Morgan Housel wrote, “Most investing is simple, but we complicate it.”
Companies earn a profit. When investors are in a good mood, they pay more for that profit. When they are in a bad mood, they pay less. Future stock returns will equal profit growth plus or minus the change in investor attitudes.
That is the essence of the stock market. But we complicate things, scrutinizing every market detail for evidence of what is coming next.
At their core, market forecasts are an attempt to predict future investors’ emotions, and there is just no reliable way to do that.
A sensible way to invest is to assume companies will earn a profit, and that the amount investors will be willing to pay for that profit will fluctuate. Those emotional swings will balance out over time, and over the long run, the profit a company earns will accrue to their investors’ pockets.
No recommendation on sentiment would be complete without taking into account the varying levels of risk tolerance. If you are a contrarian, have a strong stomach for losses, and don’t mind “looking stupid” while a stock falls after your initial purchase, then you should buy before sentiment hits the extremes. Those who aren’t comfortable catching falling knives and don’t mind missing the initial rebound in a stock should wait for sentiment to inflect.
For both investor types, defining your investment goals in advance of purchasing stocks — including return targets and stated time horizon — is the best way to maintain discipline and keep emotion out of your investing process.
A final investing proverb applies here, one attributed to Isaac Newton rather than a contemporary: “I can calculate the movement of stars, but not the madness of men.”
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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