Opinion: Five sentiment indicators are telling us it’s time to buy stocks, especially this group
If you are optimistic about the direction of the stock market and feel lonely about it, that is actually a good sign.
Historically, whenever most investors were extremely negative, the market was buying. I’m talking about contrarian thinking, telling us that doing the opposite often pays. The ad in the market summed it up: “When people cry, you better buy.” “Buying right never feels good.” “Buy when there’s blood on the street.”
But how can you really tell when “everyone is crying”? You turn to the sentiment gauge, the quantitative measure of despair – and tears -. Below is a compilation of five sentiment metrics that point to negative extremes and an anecdote for a good one.
In the spirit of “a meal for a lifetime,” I demystify these indicators and explain simple ways to interpret them, so you can refer to them for the rest of your investing life. This will not be the last bear market you will experience.
1. Investor’s Bull/Bear Intelligence Ratio
If you only follow one sentiment indicator, make it this one. This rating is based on a survey of over one hundred market newsletter writers. Historically, when the ratio of bulls and bears is below one, it is a negative psychological extreme, which tells us the market is buying. The chart below, from Yardeni Research, shows the historical perspective. The October 4 reading stands at 0.61, an extreme low indicating negative sentiment. This is a bullish signal in the opposite sense.
2. American Association of Individual Investors (AAII) Sentiment Survey
This rating is based on the weekly AAII poll of members, who are individual investors. Retail investors can be notorious mob followers, so they provide an effective sentiment reading.
You can see by this summary, below, that the data bounces pretty much. When this happens with data, analysts turn to a rolling average to flatten the variance by combining several consecutive data points. Strategists at RBC Capital Markets recommend the following tip with AAII data. When the percentage of bulls minus the percentage of bears falls below -10 percentage points on a four-week average basis, it is a strong buy signal. The 4-week average spread is now -33.7, well above the -10 threshold.
Also note that the last two price cuts in September were almost 61%. Prior to these readings, over the past 35 years the bear rate had surpassed 60% just four times. As noted by Jason Goepfert at SentimenTrader, the stock return for a year after those four events was +22.4%, +31.5%, +7.4%, +56.9%.
A simpler way to use this measure is to look at the ratio of the number of bulls to the number of bulls and the number of bears. As the chart below, from Yardeni shows, readings of 35 or less are rare, which tells us they are buyable extremes. The reading in early October was April 30.
3. US Central Bank Bull & Bear Indicator
Bank of America tracks bullish and bearish indicators for clients. It measures things like hedge fund positioning, stock market breadth, capital inflows into stocks and bonds, and the positioning of long-term funds. This point reaches a negative extreme when it is zero. It was there in early October. Investor sentiment is just as bad as it was during the Great Financial Crisis and the early days of the pandemic – both followed by a very good stock market rally.
4. Fund manager’s cash position
Bank of America conducts regular surveys of fund managers to gauge their sentiment. One way to gauge their mood is to see how much cash they hold. Moving to cash is a cautionary tale that suggests a money manager thinks stocks will fall. Historically, when the cash position in this survey was at 5% or higher, the stock market was a buy. Recent cash positions are at 6.1%, a solid buy signal.
5. Extreme valuations
Valuations measure sentiment, because investors sell stocks when they are falling in price.
Russell’s price-to-earnings ratio 2000
RUT,
A small-cap index, which recently fell to 11. This seems like an extreme as it is the lowest level since 1990 and 30% below the long-term average since 1985, according to Bank of America.
Mid-cap stocks look cheap, too, but not as cheap as small-cap stocks relative to their history. And large-cap stocks are still the most expensive. Russell’s forward P/E 1000
RUI,
The large-cap index, which recently fell to 15.5, is roughly in line with its long-term average.
But note the difference between small cap and large cap. The relative forward P/E of the Russell 2000 (small cap) to the Russell 1000 (large cap) is 0.71, well below its historical average of 1.01. It is at its lowest level since the tech bubble. This chart shows you historical views.
These valuation readings are a good buy signal. Judging by historical trends, these valuation discounts imply 13% annual returns over the next decade for the Russell 2000 and 10% for the Russell 1000. The message here is that equity stocks should be preferred. Small goods are despised right now because they are much cheaper than their history. A simple way to do this is to buy a small-cap exchange-traded fund (ETF) like the iShares Russell 2000 Growth ETF.
IWO,
An anecdotal measure
“If there was a recession, it would be the most widely expected recession ever, which means it probably won’t happen,” Ed Yardeni, at Yardeni Research, told clients. in a meeting on Monday.
He was referring to widespread concerns about the possibility of a Fed-induced recession that you now read every day in the financial press. This generous handshake is a not quite right sentiment read. Read anecdotes based on informal observations, not hard data, but they can still be quite effective.
Look for anecdotal indicators in your personal life. For example, you might have a friend or family member who always asks for stock ideas at market tops, or tells you that they sold everything and cashed in at their lows. market. If not, watch out for this person in your life. Even if you tell them they’re a good contrarian sentiment gauge, it won’t dampen the signal because psychology and habits tend to be stored in our brains.
While we’re on this topic, you can be your own best sentiment gauge. Monitor your feelings and behavior at extremes, so you can detect those signals again in the future.
As for the possibility of a recession, noting that employment remains strong, consumer spending remains strong (10% year-over-year growth in September, as observed by Bank of America clients), GDP of the Atlanta Fed Estimates show third-quarter growth at 3.9% and credit spreads not blowing away the way they usually do in a recession.
How can I be wrong
1. Sentiment indicators provide a good long-term perspective on when to buy a stock, but they do not provide precise accuracy. During the great financial crisis, the Bull Bear ratio of investor intelligence was lower than one (causing a buy signal) for more than a year before the stock market returned to an uptrend. It’s an exception, though. Usually its trips under one last several months or less.
2. Not all sentiment indicators are negative. Chicago Board Options Trading Volatility Index
VIX,
In my view, a break above 35 is needed to create a buyable negative sentiment. It only hit 33.6 on Tuesday. That’s close, but some strategists including Bob Doll at Crossmark Global Investments would like to see a rise to 40 to signal investment.
3. Wall Street “sell” strategists at investment banks have yet to turn extremely negative, according to Bank of America’s track on the measure. Banks say the metric remains neutral, but closer to buying than selling. However, for me, it might be close enough. Historically, when their sell-side strategists indicator is at the current level or below, the next 12 months return is 96% positive compared to the historical average of 82% of the time and the average return over the past 12 months. 12 months is 21%. .
That seems pretty close to a “buy” signal to me.
Michael Brush is a columnist for MarketWatch. At the time of publication, he did not hold a position in any of the securities mentioned in this column. Brush is the editor of his stock newsletter, Mark inventory. Follow him on Twitter @mbrushstocks.
