In case you missed it, the massive rally in the US stock market has led to views that the stock market is too frothy. We’re not in the business of forecasting stock market movements. Indeed, we can’t tell if a correction is due in the coming months. However, we can study the available data and consider if things are indeed overheated.
Perhaps the most famous of sentiment surveys is the American Association of Individual Investors (AAII) Sentiment Survey. The survey has been running since 1987. It asks members what they feel the stock market will be in the next 6 months. The typical AAII member is a 60-year-old graduate with a portfolio in excess of US$ 1 million.
The latest survey indicates that only 27.2% of members are bullish (vs a historical average of 38.0%) and 42.7% are bearish (vs a historical average of 30.5%). Optimism appears to be at a 9-month low and is one of the lowest readings on record. In its long history, extreme readings have been good markers of market turns.The strongest indicator happens when there are unusually high levels of neutral sentiment. Alas! The survey’s neutral respondents are in line with the historical average.
Another sentiment index is the CNN Fear and Greed Index. It measures 7 indicators. This includes the number of stocks with advancing volume, the net number of stocks hitting 52-week highs, the VIX index, the CBOE put/call ratio, stock and bond returns, market momentum, junk bond demand. The overall index is at 53 or Neutral. This compares with the index a year ago at 62 (greed levels) and in June, 58 .
Finally, we must discuss the work of Malcolm Baker (Harvard Professor) and Jeffrey Wurgler (NYU professor). They have their own indicators that interpret market mood. These are trading volume on NYSE, dividend premium (difference between valuation ratios of dividend paying stocks vs non dividend paying stocks), closed end fund discounts (whether the fund’s listed price exceeds the underlying value of security holdings), IPOs (both number as well as first day returns), and equity share out of all new issues (debt and equity). Of these indicators, only the IPO indicator is up into greed territory, the others are all in neutral or fear.
Sentiment surveys, like all wall street models are generally wrong, but occasionally useful. At turning points in the markets, or extremes, sentiment readings turn out to be useful contrarian indicators. At this point though, the sentiment surveys do not support a view that the market is overly exuberant.