Over the last few weeks I have become quite interested in both global inflation and investor sentiment. I find these are two indicators that give some direction of the markets. Unfortunately in the past it’s been an indicator of topped-out stock markets, with rising interest rates. I don’t base my investment decisions on a crystal ball, and neither should you. However the indicators are interesting to look at nonetheless.
In this post I will look at the concept of investor sentiment as a signal of market direction – which if correct is currently indicating a topped-out stock market. Coincidentally, the S&P/TSX was down 246 points today, and the Dow was down over 248 points, about -1.7% on each market.
Arriving Late to the Party
With recently rising commodity prices and low interest rates, stock markets have also continued their meteoric rise – especially here in Canada where our economy is largely based on the resource and energy sectors. Not surprisingly, oil, metals, and agricultural stocks have been fuelling exports and the Canadian stock market. That’s been a good thing for investors!
However, it looks like many investors have missed the boat on the rising stock market. Many still recovering from the shock of the 2008 crash on their portfolios, have remained in fixed-income and been reluctant to get back into stocks. That was until 2011!
Since the beginning of the year, investors have begun pouring their money back into Canadian and global equities. Here at home, the S&P/TSX composite index is up 85% from its low in March, 2009. According to a recent Globe and Mail article by David Parkinson, the Funds Investment Institute of Canada is reporting 2011 as the biggest January sales in four years. That’s a signal that Canadian investors are optimistic about the economy and the stock market.
But are they too late? In the past it would appear investors have flooded into equity mutual funds near market tops. Why? Part of that is simply RRSP season and most people are familiar with mutual funds. More importantly, it really gets back to my previous post about Risk Assessment. When times are good people feel positive about market growth, and buy equities. And when markets are down, people don’t buy equities. Ironically it’s the opposite of what investors should do – but that’s easier said than done.
The Bulls and The Bears
When I wrote that article about Risk Assessment, I didn’t realize that I was also writing indirectly about Investor Sentiment. There is quite a lot written on the subject, and of course many paid services to analyze all kinds of indexes and trading indicators – to help track Investor Sentiment (or confuse investors).
Tim Wood at the Market Oracle writes the following:
“Sentiment alone is not a timing tool for the market. But, it is useful in telling us when too many people get on the same side of the boat, which in turn tells us that conditions have ripened for a turn. I have said many times of late that the recent sentiment environment reminded me of the 2006 and 2007 period.”
Tim Wood further provides a InvestorsIntelligence Bull/Bear Ratio chart based on Market Harmonics with the S&P 500. A percentage of 72% is a very-bullish support level. In his chart, extremely bullish levels are followed by market corrections or downturns (see below).
And here is the opposite scenario from Horan Capital back in early 2009, when everyone was extremely bearish. Even passive index investors stopped buying equities, yet that was exactly the right time to buy! Investor Sentiment does provide an indicator of market direction.
I don’t base my investment decision on forecasts, and neither should you. But the indicators are interesting to look at nonetheless. Keeping a well diversified portfolio between cash, fixed income, and stocks is one way to hedge against market uncertainty.
While I’m pleased that my stock portfolio is gaining ground, and oil and resource stocks looks poised for more growth, I’m also cautious looking ahead. That means keeping to my asset allocation and keeping invested! For me that also means getting that fixed income or cash up another 10% to 40%. Likewise I’m going to hold some extra cash on the sidelines just in case there is a turn – that means opportunity!
Next week I will look at global inflation and rising interest rates.
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