Sentiment Update: New Year's Edition

Markets closed out 2013 with a dash to new highs, further amplifying talk of bubbles.  As we like to do every several weeks, let’s review some sentiment indicators to see whether or not the underlying data is indicating frothy behavior.

Unlike our last few sentiment reviews, the picture has started to lean more to the “overly-optimistic” side, perhaps giving credence to those looking for a short-term correction.  Encouraging news, though: across the board, the indicators we watch haven’t even reached levels observed in early 2011 following the 2010 market recovery and preceding the rough summer and fall of 2011.  Sentiment-wise, markets are far from reaching extreme levels.

First, let’s look at the CBOE Put/Call ratio.  We use the 10-day moving average.  High values indicate more puts trading relative to calls, hence more bearish trading activity.  Keep in mind these indicators are contrarian.  Too many bulls and the market may be due for a correction.  Too many bears, and the market may be due for upside.  The Put/Call ratio’s 10-day average at 0.715 has reached the lowest levels since late 2010/early 2011.  This is also close to some of the lowest values observed over the past nine or ten years.  Thus, CBOE Put/Call trading is showing that complacency has crept into the marketplace, though complacency is nowhere close to the complacency of the very late 1990s.  The chart follows, going back to 1995:

Next we’ll look at a separate index covering options market activity, the ISEE All-Equities Sentiment Index.  According to the International Securities Exchange, the “ISE Sentiment Index is a unique put/call value that only uses long customer transactions to calculate bullish/bearish market direction.”  In this case, higher values indicate more bullish activity and lower levels indicate more bearishness.  Like the CBOE Put/Call, we’ll take the 10-day moving average to smooth out results.  This indicator provides a more neutral sentiment picture.  The current value of 166.20 is slightly below the average of 169.74 going back to 2006.  As you can see in the chart below, extremely high values in late 2007 and in late 2010/early 2011 preceded significant equity market volatility.  So far, this indicator shows that sentiment has yet to come close to reaching extremely positive readings.

Finally, we’ll shift more towards sentiment among individual investors.  In this case we use the Farrell Individual Sentiment Indicator, which normalizes bull, bear, and neutral market readings from the weekly AAII Bull/Bear data to better capture long term sentiment trends.  In this case, we rely on the 10-week moving average of the indicator.  Values above 1.50 indicate extreme bullishness, while values below 0.50 indicate extreme bearishness among individual investors.  At 1.11, the indicator sits above its long-term average of 0.93 going back to 1987, but well below values associated with past extreme bullishness.  Interestingly, as we’ve observed in past sentiment reviews, individual investor sentiment has actually spent a good portion of the past two years probing the lower end of the range.  Mutual fund cash flow and other indicators show that many investors are only just now beginning to re-dip their toes back in the water.  This indicator provides a decent visual representation of investor reticence to get involved in equity markets since the financial crisis.

Add it all up, and we get a picture of market sentiment that is slightly above longer-term averages, but a good bit away levels associated with major market cliff-dives.  How does this fit into a potential market performance picture for 2013?  As we observed a few weeks ago, years following 20%+ up years are usually not as robust in terms of upside gains, but usually up nonetheless, with returns tracking around historic averages.  Sentiment indicators currently show that markets don’t quite have the energy-source in terms of high levels of bearishness that precede sharp, sustained, record up moves.  However, there’s still fuel left in the tank before markets become overly optimistic.  This is a sentiment picture that fits well into a view that there is a decent probability for “good” not “great” market performance this year.  We’d expect a few challenging episodes this year in terms of corrections in contrast to 2013 where the biggest peak to trough correction in the S&P 500 totaled 7.5%, benign by historical standards.