I rely on three different areas of sentiment to try to understand to what degree investors are currently embracing an asset class: what they’re doing, what they say they’re doing and simply what they’re saying. To see what they’re doing some of the best data comes from the options market. The VIX Index shows us investors’ expectations of future volatility. Because “increasing volatility” means “losses” this is commonly called “the fear index.” Right now fear is pretty much nonexistent. That big spike higher on the chart below represents the depths of the financial crisis when investors were worried the world was coming to an end. The index almost hit 90 at that point. Today it sits closer to 13.

vix

Another index based on the options market is the put/call index. Investors buy puts to protect themselves from the downside and calls to bet on the upside. When investors are buying more puts than calls it tells you folks are more fearful than greedy and vice versa. Right now they’re not doing much put buying. Every time that moving average (the squiggly blue line below) goes below 0.60 it tells me investors are too greedy and it’s pretty darn close to that right now.

put call

The problem, however, is that these two indicators work much better in indicating fear than they do in indicating euphoria. When the stock market bottomed in 2003, after the internet bubble burst, pundits worried about the low VIX reading. They worried about it for almost four years and missed the subsequent 50% in gains, in fact. So I put much more weight into fear readings than I do into complacency readings.

Another area worth looking into to see what investors are doing is equity fund flows. Clearly when investors are pouring money into the stock market it is evident here as most investors use funds rather than purchasing individual stocks. According to this chart, since the financial crisis, investors have heavily favored bonds over stocks.

Flows

 

These represent two different time frames and investment vehicles. But based on how they are allocating their capital, options traders are pretty enthusiastic about stocks prospects right now whereas fund investors, on a longer time frame, have been shunning stocks for years now.

So let’s take a look at what investors have been saying about how they feel towards stocks. There are a variety of sentiment surveys out there that basically poll individual investors to find out if they are feeling more bullish or more bearish. In fact, the latest survey from the American Association of Individual Investors was released today so we’ll use that one. Right now just about 44% of investors polled consider themselves bullish. Looking back over the past few years when the majority of investors (over 50%) consider themselves bullish it’s a pretty good time to take the other side of that trade. We’re getting close but we’re not quite there just yet.

AAII Bullish Sentiment 011713

 

Another interesting survey I came across today tracks the recommendations of Wall Street Strategists. Now most individual investors would consider these guys the “smart money.” We know better. They are human being just like individual investors and are subject to the same emotions and rational handicaps. These guys also work for firms that make money by selling you securities. For this reason alone they spend most of their time singing stocks praises. Warren Buffett likes to say, ‘asking your broker whether it’s time to buy stocks is like asking your barber if you need a haircut.’ So when they turn bearish it’s worth noting. And right now they are pretty darn bearish. In fact, this study reports that when sell-side (because they exist to sell you stuff) strategists have been this bearish in the past stocks have been higher 12 months later 100% of the time, typically by an average of 26%.

Strategists

 

Once again we have two different surveys telling us two very different things: individual investors are fairly bullish and professional strategists are really bearish. So let’s look at the last of the three sentiment tools which, as it happens, is also the least reliable. It’s the least reliable because it is completely anecdotal. What are people saying about the markets? Your friends? Your adviser? The pundits on television? Totally unscientific but many times the most valuable.

Yesterday I brought up the internet bubble and the real estate bubble and asked if you remember which of your friends got caught up in either or both. Odds are you know someone who went all in on both and this guy is worth his weight in gold. He’s your canary in the investing coal mine and maybe he’s you. Either way, ask this guy about the market every chance you get. When he loves stocks, or any other asset class for that matter, you should feel a mini-panic. Likewise, if he hates them you should get excited. Some of my best indicators are guys like this and my own gut is one of them.

In addition, it pays to listen to the pundits if only to form a general idea of what the majority are saying. In fact, this is really the only reason I ever watch CNBC or Bloomberg Television. Lately, I’ve been reading and hearing a good deal of cautious opinions towards stocks. A fair number of pundits are looking for a top but a top isn’t made when everyone is looking for it. It’s made when all those guys talking about a top throw in the towel. This is called “capitulation” and you’ll find it at every turning point in every market ever traded by human beings. The last buyer has to buy before a top is put in and the last seller must sell before a bottom can be made.

A rare opinion I read a couple of weeks ago comes from Laszlo Birinyi. He expects the S&P 500 to follow the Russell 2000 and the Dow Transports to new, all-time highs this year as, “bears capitulate and the lure of a 4-year bull market ‘pulls everyone in the pool.'” There’s that word, “capitulate.” And we have two major studies above that confirm this thesis: investor fund flows and strategists’ recommendations. Both of these are at historic levels of bearishness. Wall Street has been telling investors to sell stocks and they’ve done it. Investors may say they are bullish but they’re not yet putting their money where their mouths are. Until they do stocks can still go higher.

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