As we begin 2018, market sentiment for stocks is reaching all-time highs while bonds are reaching record lows. This may seem like a continuation of last year’s enthusiasm for stocks and pessimism for bonds; however, a year-over-year comparison offers some insight into how markets may trade this year.
We know that over long periods of time, the value of assets such as stocks, bonds, commodities and real estate is a function of the fundamental forces that affect them. In the case of stocks, the value of a company will follow its ability to generate free cash flow, compete effectively, operate at a profit and expand those profits over time. However, companies only provide an update on these fundamentals four times a year, yet we know that their stocks trade every day. Between those fundamental updates, stock prices are pushed around by many factors, including the performance of the economy at home and abroad, demand for goods and services, the level of interest rates and the desire to own a particular asset class, i.e., sentiment.
The more enthusiastic investors become about a particular asset, the more they buy. So, the measure of that enthusiasm can be found in many sentiment indicators followed by investors. Generally, these are viewed as contrary indicators so that as sentiment reaches new highs or lows, some investors become more concerned about whether or not asset prices can continue to move in the same direction. Of course, predicting the precise turn in sentiment is very difficult; however, when it reaches levels either rarely or never seen, it suggests something about the way investors feel about an asset class.
There are many sentiment surveys. Let’s examine a few to see what we can learn about investors’ current views.
In this first survey from Twitter surveyor topdowncharts.com, you can see that the equity sentiment, in blue, is at its highest level in the last year, while the bond sentiment, in black, is at a new low (it is inverted here because bond prices are generally negatively correlated with stocks).
One of the reasons for stock bullishness has to do with the prospects for stronger fundamentals in 2018. Investors are expecting that the combination of accelerating capital investment and improved tax policy will lead to higher profitability and earnings. The chart here describes sentiment based on fundamentals. This chart is created by asking investors whether they believe asset prices will be higher due to improving fundamentals. Again, you can see that equities sentiment is at a high while bond sentiment (still inverted) is at a new low.
Here is a different way of measuring sentiment from Ed Yardeni. He takes a consumer comfort index, and a boom-bust barometer which measures the price of commodities divided by the four-week moving average of unemployment claims, to determine this measure. As you can see the measure (in blue and S&P 500 Index in red), generally peaks before the market, so it provides some evidence that a peak in sentiment can be a turning point for prices. As this chart goes back to 1992, it is interesting to note that the current sentiment measure is well above the 2007 and 1999 highs.
The Investor Intelligence survey of sentiment has been around for a very long time. The chart below goes back to 1987 and shows the ratio of those who are bullish with those who are bearish on the future for stock prices. As the line moves higher, the bulls outweigh the bears. The higher the ratio, the more bullish investors. Once again, you can see that the current ratio is higher than the 2007 and 1999 peaks. You have to go back to the 1987 market to find a higher ratio. You’ll also notice that much of this increase took place late in 2016 and throughout 2017 as the economy improved and corporate earnings growth accelerated.
Using sentiment to predict a peak in prices is not worth the exercise. The market can continue to move higher, as can sentiment, for longer than anyone may predict. It is useful, however, to understand whether or not investors are beginning to price in more good news than we’ve received. The higher the sentiment readings, the more important it will become that things like positive economic and earnings growth surprises continue in order to satiate investors for their optimism. After a big year for stock returns in 2017, investors are enjoying a Happy New Year.