Although media headlines, podcasts, and broadcasts may suggest that there is impending “doom and gloom,” investor optimism has significantly increased since the October lows. This is not the first time that investor sentiment has been discussed, as it is often inaccurate at the extremes.
“One of the hardest things to do is go “against” the prevailing bias regarding investing. Such is known as contrarian investing. One of the most famous contrarian investors is Howard Marks, who once stated:
‘Resisting – and thereby achieving success as a contrarian – isn’t easy. Things combine to make it difficult; including natural herd tendencies and the pain imposed by being out of step, particularly when momentum invariably makes pro-cyclical actions look correct for a while.
Given the uncertain nature of the future, and thus the difficulty of being confident your position is the right one – especially as price moves against you – it’s challenging to be a lonely contrarian.‘” – Sentiment Is So Bearish It’s Bullish. – Lance Roberts
That bolded sentence is the most relevant to today’s discussion.
Investors tend to make the most mistakes at points where sentiment readings are extreme, whether they are bullish or bearish. This is due to investment decisions being driven by the emotions of “fear” or “greed.” In terms of contrarian investing, we should aim to be “buyers” when everyone else is selling and “sellers” when everyone else is buying.
However, this can be challenging because our own emotions often push us to “follow the crowd.” Howard Marks recognizes that being a contrarian can be both difficult and isolating, but it is frequently the correct approach.
The chart below depicts a weekly composite index of investor sentiment, showing only those periods when investors are exceedingly bullish or bearish compared to the S&P 500 index.
It is not recommended to utilize sentiment as a timing indicator for investing since extreme bullish or bearish sentiment may persist for prolonged periods as price momentum trends upward or downward. However, recognizing that extreme bullishness or bearishness frequently signifies market excesses is critical for tempering our emotional biases.
Furthermore, as investors, we must acknowledge that while extreme bullishness or bearishness is often incorrect, investor sentiment is typically accurate in the middle of the trend.
When Investing, Star Wars Is Wrong
In several scenes throughout the Star Wars films, characters are instructed to “search their feelings” to uncover their true beliefs. However, as humans, we have a tendency to extrapolate temporary events as permanent trends, particularly when it comes to investing. We believe that markets will continue to rise indefinitely when they’re up and that they’re headed to zero when they’re down. Neither of these beliefs is accurate, and they are also the underlying “fallacy” behind both “buy and hold” investing and “compounded” market returns.
A brief examination of market history demonstrates that markets do not rise or fall indefinitely, and periods of bullishness inevitably lead to bearishness. The chart below compares the Dow Jones Industrial Average’s actual value to what it would be if it increased by 5% per year (as per the buy and hold theory). The difference in ending values is caused by periods of falling returns that reverse previous periods of growth. It’s crucial to note that periods of declining values undermine the compounding effect.
Right In The Middle, Wrong At Both Ends
As mentioned earlier, investor sentiment is usually correct in the middle of a trend but wrong at extremes. If we refer back to our weekly composite sentiment index, we can see that it is increasing after hitting an extreme low.
Looking back at the 2008 period, we can see that sentiment can remain at a low level for an extended period. However, once it begins to increase more consistently, this can often indicate the equity market low. This may be what we are currently witnessing.
Despite professional investors’ expertise, they are also subject to emotional biases that influence their investment decisions. The National Association of Active Investment Managers (NAAIM) monitors its members’ average exposure to U.S. equity markets. Historically, when this index falls below 40% exposure, it aligns with market bottoms, whereas exposure above 90% aligns with market peaks.
The volatility index (VIX) is another indicator of market sentiment, and it also suggests that the market low occurred in October. When the market experiences extreme panic, the VIX tends to reach high levels at or near market lows. In bull markets, the VIX generally declines from a previous peak. The 2022 market selloff was a correction within an ongoing bull market, as evidenced by the VIX peaking around 30. With the VIX now declining, this also suggests that October was the correction low.
The current market conditions do not display excessive bullishness but show fading extreme bearishness. The recent rally since the start of the year could indicate the return of the bull market or could be a temporary “bear market rally” luring investors before a further decline. However, it is hard to predict the market’s direction, and we can only tell in hindsight. Nevertheless, history shows that rising bullishness from extremely low readings has led to a more extended market advance, often known as “climbing a wall of worry.”
It can be tempting to let the numerous headlines, podcasts, and media predictions influence our emotional biases. However, it is crucial to stay focused on the market’s actual performance instead of what we believe it should be doing.
“More money has been lost trying to avoid bear markets than has been lost in any bear market.”– Stephan Cassaday.