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Investor Sentiment: The Market Climbs a Wall of Worry  Thumbnail

Investor Sentiment: The Market Climbs a Wall of Worry

The most famous investor sentiment quote is likely one from the Oracle of Omaha: 

“Be fearful when others are greedy, and greedy when others are fearful.” 

– Warren Buffett

I've been monitoring investor sentiment since the 90s when it was as extreme as it's ever been, and it mostly cycles from extreme highs to extreme lows.

When investors get extremely optimistic and bullish about a future uptrend it's typically after prices have already trended up for some time. 

When investors get extremely afraid of losing money and bearish about the future direction of the stock market it's well after prices have already fallen, a lot. 

While our primary strategy is to position our capital in the direction of price trends, they sometimes drift too far, too fast, so investor sentiment measures help signal when an uptrend has overreacted to the upside and a downtrend has overreacted to the downside.

Another related famous quote: 

“The trend is your friend until the end when it bends.” – Ed Seykota

Most of the time price trends swing between these extremes and just trend directionally as investors underreact to new information, causing the price to drift over time to its next new value. 

Investor behavior is complicated, but after observing sentiment for more than two decades I primarily see them oscillate between the fear of missing out, and the fear of losing money. 

It's not enough to generate asymmetric investment returns through the process of tactical trading, we also have to keep an eye on behavior and help our clients avoid the mistakes many tend to make.  

With all that stage setting, here's what we see today. 

Investors Intelligence reports weekly the percentage of bullish and bearish market letter writers it tracks. A reading of 1.00 or lower is a relatively lower-risk time to buy stocks, an indication to "buy fear." But it remained below 1 for much of 2022, typical of bear markets.

Investors Intelligence also reports on a weekly basis the percentage of market letter writers who are in the correction camp, anticipating a selloff but not an outright bear market. It's at 32%, but not extreme.

Pessimism among individual investors decreased but remained above average for the sixth consecutive week in the latest AAII Sentiment Survey.

The panic/euphoria model is a gauge of investor sentiment. Currently below -0.17 indicates panic, and it's at -0.31. Historically, a reading below panic supports a better than 95% likelihood that stock prices will be higher one year later, while euphoria levels generate a better than 80% probability of stock prices being lower one year later.

The Cboe Implied Volatility Index uses options on the S&P 500 index as a fear gauge based on how much expected price movement is reflected in options premiums.

The VIX is mean reverting, and cycles from high to low based on the cost of insurance.

The VIX trends down before a hurricane and spikes up after a hurricane hits. The best time to buy insurance is when no one expects a storm. 

The chart of the VIX shows implied volatility is at the lowest level it's been the past year, so fear of more volatility expansion is fading. 

As I warned last year, this has been a very long drawn out bear market, and we haven't seen an economic recession yet. 

After tactically operating successfully though the big bear markets since the 90s by learning from past cycles, we can expect many swings up and down. 

The S&P 500 index is at the same level it was two years ago, but it's trended up and down ~25% along the way. 

As the price trend and implied volatility oscillates back and forth, it also creates patterns in realized volatility itself.

Recently, we've seen a divergence between VIX (expected future volatility) and RVOl (Cboe Realized Volatility Index) indicating expected vol is now lower than realized historical vol.  When IV is less than HV, it suggests options on the SPX index are a good relative value. 

Here's a look over the past year. Implied volatility is overstated about 87% of the time, so it's rare to see IV less than realized. In this chart, the darker line is realized volatility per the Cboe RVOL which is a one month (21 trading day) standard deviation. The lighter line is VIX, the 30 day expected vol.   

Image Caption

Investor sentiment is highly correlated with realized volatility, as we see in this visual representation comparing individual investor sentiment (red) with the S&P 500 price trend.  

By and large, the market is now signaling an imminent end to the Fed hiking cycle.

Stocks have typically trended up in the months following the end of past Fed hiking cycles, with an average 3-month gain of +8% for the S&P 500 in 5 of 6 cycles since 1982.

However, stocks performed poorly when the economy entered recession near the end of tightening cycles, and a recession is most likely from here.

As of yesterday, the Atlanta Fed GDPNow model estimate for real GDP growth in the first quarter of 2023 is 2.5%, down from 3.2% on March 24.

As highlighted on the chart, the 10 - 2 year hasn't been this inverted since the 1980s, and and inversion has predicted every recession.  

The trouble (risk) with trading macro expectations is the market doesn't respond as it did in the past, and often there's a small sample size to draw inferences.

(Risk = possibility of a bad outcome.)

We believe the way to grow capital long-term is through risk management to avoid the negative effects drawdowns have on compounding and letting the winners run.

It necessarily requires us to focus on the absolute price trends themselves. 

Some positives we've seen up until now is improving breadth. 

 S&P 500 Stocks Above 50-Day Average. The broader the participation of stocks in an uptrend, the more likely the trend is sustainable. If a rally is led by fewer and fewer stocks, it might be more vulnerable to falling apart.

Looking at a longer time frame we monitor the S&P 500 Stocks Above 200-Day Average.

In both charts I included a linear regression with one standard deviation to indicate the overall direction of breath, which is down, but in the upper range that could be broken if more stocks keep trending up. 

Notice I didn't even mention the multi-billion dollar bank failures the last few weeks.

That's because the price trend is the final arbiter.

Who would have believed the stock market would trend up a few percent after such events as global bank failures? 

The market climbs a wall of worry. 

We know these are trying times and it's likely far from over. The risk from here is there is much more chop, and lower lows.

If you or anyone you know needs advice or investment management, contact us.

We have one of the strongest track records in volatile conditions like these and this is where our tactical systems shine. 

Mike Shell is the founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Managed Portfolios. Mike Shell and Shell Capital Management, LLC is a registered investment advisor focused on asymmetric risk-reward and absolute return strategies and provides investment advice and portfolio management only to clients with a signed and executed investment management agreement. The observations shared on this website are for general information only and should not be construed as investment advice to buy or sell any security. This information does not suggest in any way that any graph, chart, or formula offered can solely guide an investor as to which securities to buy or sell, or when to buy or sell them. Securities reflected are not intended to represent any client holdings or recommendations made by the firm. In the event any past specific recommendations are referred to inadvertently, a list of all recommendations made by the company within at least the prior one-year period may be furnished upon request. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities on the list. Any opinions expressed may change as subsequent conditions change. Please do not make any investment decisions based on such information, as it is not advice and is subject to change without notice. Investing involves risk, including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. All information and data are deemed reliable but are not guaranteed and should be independently verified. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. The views and opinions expressed in ASYMMETRY® Observations are those of the authors and do not necessarily reflect the position of Shell Capital Management, LLC. The use of this website is subject to its terms and conditions.