Market Sentiment is Over-Believed but There is a Silver Cloud
January 14, 2010
The Current "highs" in investment sentiment have been very much on our minds since September of last year. However, as in the 2003 to 2004 recovery when sentiment hit "75," we were hopeful we would see a blow off in sentiment before any meaningful short-term decline.
This week we saw a break out over 66 in the Ned Davis Research sentiment indicator, and we can see from the top chart below, it closed at 69.6.
The first two charts below show the extent at which this rally is overvalued on a price to sales basis, and over-believed in terms of sentiment. However the last two sentiment charts below show that there is room for sentiment to move higher in the short term, in particular, if you compare the sentiment highs hit following the 1974 bear market low.
This does not mean that markets are going to fall apart any time soon. It does, more importantly, indicate that the RISK in searching for future 12month returns are higher than a year ago. Fear and greed has just once again switched places.
However there is a confusing Silver Cloud on the horizon, as pointed out by Mark Hulbert in his latest Market Watch column.
But recently released fund-flow data for the month of December report a different story entirely: Mutual-fund investors, on balance, remain skeptical of the stock market's monster rally of the last nine months, betting that it will not continue.
In fact, according to TrimTabs Investment Research, December was the fifth month in a row in which mutual fund investors pulled more money out of domestic equity mutual funds than they put in. The month's net outflow came to $7.2 billion, bringing the total since the beginning of March to $29 billion, according to TrimTabs.
It is quite unusual for mutual fund investors to have reacted to the rally in this way. The normal pattern is for fund investors to pour increasing amounts of money into the stock market as it rises, and to pull money out at an accelerating pace as the market declines.
By the way, don't think that fund investors' recent behavior is the result of their transferring funds to the increasingly popular world of exchange-traded funds. For all of 2009, according to TrimTabs, there was a net withdrawal from domestic equity ETFs too.
There is a precedent, and we must look back again to the rally following the 1973 to 74 bear market: Investors consistently took money out of mutual funds as the market recovered back to the old 1973 highs and then every calendar year until 1982.
In Summary:
In managing exceptions in terms of what type of returns to expect over the next 12 months, we turned to OSAM's research in their January 2010 note. It found that The average return in the first year of a recovery following a severe bear market is 46 to 61 percent; the second year, 14 to 15 percent; and the third, 1 to 3 percent.
Therefore, it would be prudent to lower our expectations for the year and expect the market to return about 14 percent, which would give the S&P 500 a target of about 1300. While not wanting to fight the tape, we believe it is prudent given the short-term excessive optimism, to raise our short-term stop-loss to 1080 on the S&P 500. A break of that level would force us to take a more cautious portfolio stance, until valuation and sentiment returns to more attractive levels.
