Market Sentiment Leaves Me Bullish

I have a confession to make.

When I try to divine short-term market movements, I have a distinct weakness for this fuzzy thing called “market sentiment.”

As a member of the exclusive clan of Chartered Financial Analysts (CFAs) — schooled as we are in the rigors of modern quantitative finance — that admission is borderline heresy.

In world awash and bedazzled by complex financial models, “market sentiment” doesn’t have the perceived legitimacy of, say, looking at a company’s balance sheet, or income statements or cash flows.

Yet, the elephant in the room is that the short-term prices of financial assets are driven by little else.

And thanks to sites like SentimenTrader, it turns out market sentiment can be quantified — sliced and diced into numbers, graphs and charts just like any fundamental data can.

And before you dismiss market sentiment as yet another incarnation of spurious financial astrology, consider this. Warren Buffett earned his investment spurs as a Ben Graham disciple and a value investor. And Buffett has said that the single-most-important thing he has ever read was Graham’s chapter on Mr. Market’s Moodswings in “The Intelligent Investor.”

In that chapter, Graham compares the market to a manic-depressive. Some days, Mr. Market is euphoric. On other days, he’s very depressed. If you catch him on a euphoric day, he wants a very high price for his shares. If he’s in one of his down moods, he’s willing to sell you his shares for a pittance. Mr. Market highlights the one thing you can predict with certainty about financial markets: investors will always overreact to events — whether positive or negative.

For my money, it’s a darn good way of looking at things.

What Sentiment Tells You about Today’s Market

Investors came into 2014 with a chipper attitude. Whether investment newsletter writers, fund managers or mom ‘n pop retail investors, everyone was bullish on the market.

Of course, investors had reasons to be cheerful. The major U.S. indexes soared 30% or so in 2013 and both the Dow and S&P 500 hit record highs. The market’s rise was remarkably smooth and resilient. Even the beginning of the end of Quantitative Easing (QE) couldn’t slay the market bull. As Morgan Stanley’s market strategist Adam Parker, put it, “The only thing people are worried about is that no one is worried about anything. That isn’t a real worry.”

Truth be told, it is comments like Parker’s that have me worried.

Last week, many of my favorite sentiment indicators hit levels that have often preceded sharp pullbacks.

SentimenTrader’s index of “dumb money” confidence exceeded that of the “smart money” by a level seen only three other times over the past 27 years. No wonder a handful of value-oriented mutual fund managers have ramped up their funds’ allocation to cash, leaving stock exposure at the lowest level in 13 years. That’s also why I recommended to subscribers of my short-term trading services, Bull Market Alert and Triple Digit Trader, that they reduce their exposure to the market.

Bull Markets Climb a ‘Wall of Worry’

As I’ve written before, I prefer to buy assets when bad news hits the cover of the Economist magazine. As Buffett says, “the market pays dearly for a cheery consensus.”

The last five years are a terrific case study of how financial markets “climb a wall of worry.” Remember Europe’s coming implosion; the looming U.S. government bankruptcy; or my favorite, China’s coming collapse? Yet, with U.S. stock prices up 176% since March 2009, this has been one of two great bull markets since the dotcom bust.

The irony, of course, is that even as investors turn bullish, stocks actually become riskier. After last year’s big run in the United States, valuations jumped. In 2013, the price/earnings ratio on the S&P 500 rose to 15.4 times estimated earnings for the next 12 months. That’s far above a 10-year average of 14.

So what’s my outlook based on today’s market sentiment?

Despite my caution over the short term, I am firmly in the bull camp over the coming years.

Right now, investors’ optimism is based on a collective sigh of relief that the worst is over.

On the one hand, that means it will take genuine good fundamental news — and not just the absence of financial crises — to keep stock prices going higher.

On the other, even as the U.S. market hits record highs, global stock markets are hardly partying like it’s 1999.

And as John Templeton said, “Bull–markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.”

And for all of the talk of “bubbles,” I think we are barely out of the “pessimism” phase of Templeton’s formulation.

My advice?

Endure the inevitable short-term market corrections stoically.

And as the stiff-upper-lipped Brits say, “Keep calm and carry on.”

In case you missed it, I encourage you to read my e-letter column posted last week about the Obama presidency disappointing as expected. I also invite you to comment in the space provided below.