Sentiment Picture: Q1 End

After a full quarter of “dog chasing its tail” type action in global markets, various global indices ended Q1 at or near highs.  All of this happened in spite of a backdrop of China fears, Ukraine fears, polar vortex fears, US growth fears, valuation fears, European deflation fears, fear of flying, fear of Ebola, and fear of earthquakes.  After everything US and global markets have “endured” these first three months, we’ve been rather impressed with market resiliency.

Following whirlwind quarters like the one just experienced, we like to check in on how various sentiment indicators in the marketplace are lining up.  When the market is breaking to new highs, we’re always a little more encouraged when sentiment leans to the dour side.  Interestingly, that’s exactly what’s happened.  The sentiment indicators we follow indicate mild caution, which we’ve found generally supportive of market performance.  

Let’s begin with the US CBOE equity Put/Call ratio.  Again, we use the 10-day moving average to smooth out some of the noise.  Last time we checked in ahead of the Q1 market correction, this indicator had hit some of the lowest (more bullish) levels observed over the past several years.  The correction and general negative noise in the marketplace have brought this indictor back above the long-term median and back to the middle of the range observed over the past several years despite the fact that the S&P 500 has moved into new all-time (nominal) high territory.  

Next, the ISES All Equities Sentiment Index, which also captures sentiment in the options market, shows a similar picture.  At the beginning of 2014, the 10-day average had reached the highest levels (more optimism) in two years.  Since then, at 152.50, the indicator has dropped back into the more cautious “wall of worry” range it’s occupied since early to mid 2012.  

The Farrell Individual Investment Sentiment Indicator uses the bull/bear/neutral readings each week to provide a picture on overall sentiment.  Sounding like a broken record, this indicator had moved above historical median early this year towards the highest levels observed since early 2011.  Since then, even with market grinding higher, the 10-week average has now moved back below median levels.

Finally, the 4-week moving average for the BNP Paribas Love-Panic Market Timing Indicator gives a picture of sentiment over in Europe.  Europe has been acting swimmingly of late, yet sentiment remains in neutral territory.

Taking all into consideration, market participants aren’t demonstrating outrageous pessimism.  Nonetheless, it’s interesting and mildly encouraging that investors maintain a healthy dose of skepticism while global and US markets have found a way to move towards new highs.  Likewise, though there’s been some noise associated with weather in the US and abroad, there’s no indication at this point that developed market economies face immediate recession dangers.  The overall backdrop isn’t completely hunky-dory for markets.  For instance, we remain concerned intermediate-term about valuation levels in the US markets.  Until we see a combination of overly optimistic sentiment, negative market momentum, and cracks in the growth trajectories for the leading developed markets, we’ll have to give equity markets the benefit of the doubt right now.

Bracketology and Value

Granted, there’s still plenty of time left in the NCAA tournament (and a number of games to lose), but after last night’s Sweet 16 matchups, this writer finds himself in first place in one large competitive bracket and two points out of first place in another.  In both cases, the brackets are at or near the top in terms of possible remaining points.  I wish I could tell you this was the result of some magnificent accumulation of college basketball wisdom or hours upon hours of diligent bracket study.  In reality, it’s no exaggeration to say that I’ve not watched one entire college basketball game this entire season, perhaps not even one complete half.  Embarrassingly, I’ve listened to several of the better tourney games driving in the car and had to pay very close attention to the team possession information because none of the players’ names ring a bell.  I’m so ill informed that I become confused and tune out. 

How could this happen?  Instead of poring over bracket decisions, I decided to blindly follow the bracket recommended by a leading statistical expert, who used several relatively simple inputs to develop probabilities for each game, start to finish.  My brackets took me less than five minutes to fill out.  The past several years prior, I used a different statistical model to fill out brackets with similar solid results.  These past brackets were filled out quickly, the morning of the first games.  I’ve never won, and I probably won’t win this year due to randomness and dumb luck, but I’ve always been smack-dab in the running the final week and finished near the top.  Separately, over the past seven or eight fall college football seasons, I’ve participated in a running weekly pick-em pool that involves roughly 25 games per week over the course of the entire season.  Beginning year before last, I abandoned qualitative judgment and picked solely on a publicly available statistical model.  Each week, I purposefully ignore all qualitative information and pick solely based upon the model, no matter how badly my brain wants to change some of the answers.  The results: a first place finish the first year and a third place finish this past year.  

What does this have to do with value investing?  A bunch, actually, in our opinion.  In past blog posts, we’ve talked about the “fundamental free lunches” available in the equities market place.  Simply, we’ve shown that buying individual stocks year over year that are bottom of the barrel in terms of quantitative valuation according to several simple fundamental metrics leads to statistically significant long-term outperformance.  You literally didn’t need to know one thing about any of the stocks picked through the years to achieve the outperformance over the long run.  Actually, in most cases, the stocks picked would have caused the rational part of your brain to go entirely haywire.  By nature, many true value stocks have fallen out of favor for one reason or another, whether management problems, fraud, secular industry decline, or product issues.   Yet, time and time again, a number of these names eventually revert back to the mean generating solid returns.  On the flip side, the highflying names that are usually showing up on the front covers of the daily business papers and weekly magazines are overvalued and prone to revert downward over time.  

Like the NCAA bracket and college football examples above, the value investing process is ultimately a probability issue.  Our simple examples in past blog posts and a bunch of academic research shows that if you pick bottom decile stocks valuation-wise, for instance, the odds work in your favor that portfolio performance will come in above the averages over longer time periods.  Unfortunately, the human brain is subject to a number of biases that lead us to make a bunch of regrettable decisions.  In the bracket examples above, objectively picking using the statistical model eliminates the biases we have from a number of different directions, such as tendencies to pick traditional powerhouse teams, or to favor teams from a certain conference or geographical region, or that have a star player we really like.  In the stock-picking world, similar qualitative biases lead us to shun the cheap companies and chase the overvalued.  Our brains tell us to avoid the undervalued because the management team is in turmoil perhaps, or because the last product was an absolute flop.  Meanwhile, we buy because the CEO is on the cover of Forbes, or because their particular widget is the darling of the tech or retail world.  Doing so leads to substandard returns.  Several studies, for instance show that retail and institutional investors generally have an awful market-timing track record, buying wholeheartedly at market peaks and selling hand over fist at market bottoms.

There are caveats, however, to taking objective approaches.  

• First, you need to find the right metrics or models.  In the investing world, we know that certain fundamental multiples like price to book and EV/EBITDA are far better long-term performance predictors than metrics such as forward P/E ratios.  In our NCAA bracket and football examples above, we used models that have been developed over long periods of time.  A tourney bracket based upon the relative positions of the moon and stars in the sky at various points during the tourney probably wouldn’t get you very far.  Keep in mind, it’s important not choosing metrics or models because they tell you what you want to hear all the time.  
• Second, you have to commit yourself to the process and maintain discipline, no matter how bad it hurts.  In value investing, it’s easy to come up with a million different reasons why a certain company’s stock shouldn’t get consideration.  There are ways to mitigate this anxiety.  For instance, one can employ risk management rules or technical analysis to ensure that a particular name doesn’t harm performance in an outsized way.  Nonetheless, even with risk procedures in place, it’s very difficult mentally to get involved in names that aren’t necessarily belles of the stock-picking ball.  Likewise, in clicking the teams for my bracket, rest assured there were many tempting overrides.  
• Third, and perhaps most important, one has to understand that taking probabilistic approaches doesn’t guarantee you win every time period.  Patience is absolutely a key part.  Consistency becomes more important than shooting the lights out.  In markets, sometimes value is in favor, sometimes it isn’t.  In past blog posts, we showed several year stretches where certain fundamental metrics underperformed only to come back with a vengeance on the upside.  Many investors lose patience with a process due to a stretch of underperformance and abandon the process at precisely the wrong moment instead.  Our “humanness” gets in the way.  Take the football pool.  On the way to those first and third place finishes, this writer rarely won the weekly intervals outright.  However, rarely were the picks at the very bottom of the pool in any given week.  Surely, a few weeks were stinkers, but the odds eventually won out over the course of 14 weeks.  Grind-it-out consistency is the central idea, not too dissimilar to the tortoise vs. hare example.

We’ll see how the rest of the tourney plays out.  Whether the bracket finishes first or not, we know it’s been a good run.  Plus, we’ll know the outcome one-way or the other within a week!  Markets, however, test patience, consistency, and discipline over years and decades.  Academics and investors have asked repeatedly how efficient or moderately efficient markets can continue to offer a value premium over long periods of time.  Perhaps it’s best summed up in quote attributed to John Maynard Keynes: “Markets can remain irrational a lot longer than you and I can remain solvent.”  

Leading Indicators Review

After several polar vortex rounds, several snowpocalypses, and a fair share of other North American weather calamities, it’s been hard to suss out the true US economic position.  Recent economic news here has been weaker than expected, as shown by the recent downward move in Citigroup’s Economic Surprise Index.  Debate continues as to whether the weakness is temporary in nature.  Throw in Putin’s Ukraine misadventures and we see that global economic news has become scrambled as well.

Accordingly, we thought it might be useful to quickly review some of the US and global economic leading indicators we follow to see if the global economy remains on track for a steady recovery.  In our work, leading economic indicator indices have been solid predictors of market trouble when flashing recession warning signs in conjunction with high multiples and waning market momentum.  As we’ve mentioned in several posts, the US remains overvalued historically using various long-term valuation metrics, while overseas developed markets, for the most part, are neutral valuation-wise.  Long-term market momentum is intact.  Now let’s look at the economic outlook.

Starting with the US, despite some recent weakness, the economy appears to be on track for decent forward growth.  Using a 12-month rate of change, 6-month smoothed indicator for the Conference Board LEI, we see the indicator firmly in positive territory.  Prints below zero indicate high recession probability. As you can see, the string of sub-par data didn’t significantly affect leading indicators, or at least not yet.  

Source: Conference Board, Bloomberg, and IronHorse Capital

 Next we’ll turn to the Philadelphia Fed’s “Anxious Index” for an alternate view of future economic prospects.  Going back to 1968, this indicator is generated from surveys sent to economists by the Philadelphia branch asking for their view on recession prospects in coming quarters.  When this indicator moves above 30, recession prospects are very high.  Like the LEI, this has been a decent recession indictor, though the lead-time appears more compressed.  The Philly Fed’s Anxious Index is now updated through Q1:2014.  Again, we see the indicator residing in space generally associated with low risk of recession and solid growth.  The Anxious Index has actually declined steadily over the past six quarters.

Source: Federal Reserve Bank of Philadelphia

Turning to Europe, we’ll use the OECD leading indicators to provide a view.  Like the Conference Board indicator in the US, we use the 12-month rate of change, 6-month smoothed indicator to indicate recession risk.  Levels below zero indicate high probability of future recession.  Like the US, Europe’s indicator remains firmly in positive territory.  

Source: OECD, IronHorse Capital

Next, we’ll look at Japan.  The longer-term chart for Japan presents an interesting picture, capturing the longer-term downward trajectory from the boom years of the 60s, 70s, and 80s.  Since the mid-90s, we see a steady stream of economic dips.  Abenomics has pushed the leading indicators out of recession prediction territory in 2012.  Right now, the economy looks to be in solid territory for the next few quarters at least. 

Source: OECD, IronHorse Capital

Finally, we’ll look at Australia, which is a key component of the EAFE.  Like the others above, growth at this point should remain solid over the next few quarters.

Source:OECD, IronHorse Capital

Put it all together, and we see a world where economic growth over the next several quarters should remain intact.  Granted, very few expect growth to knock the lights out globally, but that doesn’t matter.  As long as future recession probabilities remain low, we have a hard time seeing the beginnings of a major market dislocation along the lines of ’08, etc.  Certainly, in the US and some other areas, elevated long-term valuations open up the possibility of corrections.  The beginning of this year reminded investors that markets have the ability to back-and-fill quickly.  Until we see leading indicators roll over across the board, however, we’ll remain in the camp that markets will churn sideways worst case (think this quarter for global equity markets) and grind higher best case.  

Valuation Review: Spring Break Edition

Markets around the world continue the 1^st quarter churn after a superb 2013.  Coming into today (Friday) many developed market indices remained stuck in a performance range within relatively close proximity to the zero line, though Japan is off to a very poor start after an extraordinary 2013 (Topix down nearly 11% YTD).  Amazingly, emerging markets continue the free fall observed over the past year.  The MSCI Emerging Market Index is down nearly 6% YTD coming into today vs. approximately -1% for the MSCI EAFE and flat for the US S&P 500.  

Reviewing valuation around the world near the end of Q1, we continue to see a world where the US appears moderately overvalued using long-term valuation metrics, developed Europe hovers around median valuations, periphery Europe remains near the bottom of the valuation tables, Japan is over-extended, Asia ex-Japan is mixed, and emerging markets remain undervalued overall, though individual countries present a more mixed picture as well.  

Against the valuation backdrop presented below, we remain more sanguine longer-term on ex-US equity markets and believe talk of a new long-term secular bull market in US markets is a bit premature at this stage.

Finally, a few notes: to calculate long-term P/Es, we use Bloomberg earnings data to calculate the trailing 10-year average earnings for each country’s primary index.  P/E ratios are inflation adjusted using OECD inflation indices for each individual country.  

As we always point out, long-term real P/E ratios aren’t suitable for making short-term timing decisions but demonstrate solid statistical significance in terms of predicting long-term returns, i.e. annualized returns over the subsequent 7 to 10 years.  

	10-Yr P/E Ratio		YTD Perf 2014
Japan	23.34		-10.53%
US	21.01		0.37%
South Africa	20.67		1.00%
Germany	20.00		-1.78%
Canada	19.22		5.16%
India**	18.31		3.02%
EAFE****	17.99		-2.75%
Taiwan	17.84		1.23%
Mexico	17.53		-11.29%
South Korea**	16.44		-4.54%
Australia	16.21		1.16%
Britain	16.04		-2.31%
China	13.79		-5.27%
EmMkt****	12.14		-7.93%
Hong Kong	12.09		-7.18%
France	12.02		-1.83%
Italy	11.82		7.49%
Greece	11.03		13.48%
Brazil**	11.01		-12.16%
Spain	10.75		-0.33%
Russia	5.57		-17.73%

Returns through mid-day 3/14/14

**Simple return calculations

****YTD Index ETF return through mid-day 3/14/14

Discipline and Stockpicking

Flip through all sorts of market-related news and literature, and the term “stockpicker” will pop out over and over.  “It’s a stockpicker’s market.”  He/she is a “good stockpicker.”  Nearly every manager would tell you one on one that he/she is a strong “stockpicker” capable of beating the broader averages, though we all know statistically only so many can deliver excess returns in any given year, and very few can do it consistently.  Iconic investors such as Warren Buffett and Peter Lynch fall in the rare long-term consistency category.  For every member of this elite club, however, there are thousands of incredibly intelligent, talented, and diligent individuals that have struggled. 

We thought about stockpicking in general and some of the attributes that separate successful investors from the rest when it comes to choosing individual stocks.  Noodling around the topic, one word seems to thread through the entire thought process: discipline.  Below, we highlight a few attributes we think help separate the better stockpickers from the rest.  Again, discipline seems to be the major tie that binds.

• Consistent Process:  There are innumerable ways to approach stockpicking.  Successful investors have employed many different strategies through time to achieve success.  Whether using deep-dish fundamental analysis based on complex modeling and ratio analysis, or technical analysis using charts and various price-related tools (or some combination of the two), it seems that the most successful stockpickers have been able to distill which factors deliver the best performance within their stated risk/reward parameters, develop a decision-making process that incorporates these factors, and use this process consistently, good times and bad.  More often than not, the successful processes are relatively simple.  Read about many of the successful investors of the past century, and you’ll find that many of them focus(ed) on a relatively limited set of valuation and/or technical tools.  In markets, complexity is usually the enemy over time, mostly because it’s very difficult to consistently execute an overly complex process over time.  Furthermore, objectivity is key to maintaining consistency.  Convoluted processes allow nasty human emotions to creep into the analytical process, eroding objectivity and consistency, especially when prices are moving the wrong direction.  Consistency, objectivity, and simplicity within a process allow one to confidently ignore naysayers and purchase before the herd.
• Patience:  Of course this is related to process above.  Without a solid process and consistent set of parameters driving buy/hold/sell decisions, it’s very difficult to maintain the patience and discipline required to achieve strong returns in an individual stock.  We’d all like every name we purchase to go up significantly in a straight line from the moment we purchase the name, then tell us in neon letters when it’s time to move on.  As we’ve oft stated, the market works hard to generate the greatest number of fools possible.  When buying value names especially, there can be significant turbulence that can test the most strong-willed human being.  The best stockpickers seem able to ignore turbulence and market noise and keep the eyes on the longer-term return profile.  It can take a long stretch of sideways, frustrating price movement before a market begins to recognize the true value in a name.  Discipline and patience fortified by process minimize emotional distractions and mistakes.
• Risk-Management:  Companies and the environments they operate in are very complex obviously.  Even the best stockpickers would tell you that there are unanticipated significant issues that arise over the course of owning individual names that materially change the calculus of ownership.  When those issues arise, it’s often better to move on and ask questions later.  Dogma, emotional attachment, or complacency can lead to massive performance killing losses.  Over the past decade, think about the many investment professionals that stuck with the Enrons and Worldcoms and Lehmans of the world to the lows.  Again, discipline and process are key components.  Whether using technical tools, stop-losses, or any number of other tools, many of the good stockpickers would say that preserving precious capital and keeping it from falling into major sinkholes is key.  Keeping that “powder dry” allows one to direct capital to strong risk/reward situations, or at least live to fight another day.

We’ve discussed market noise and emotional investing on several occasions.  The biggest mistakes most deleterious to performance over time, such as chasing overvalued hot stories or strong price movers and getting caught up in herd behavior, are the direct result of allowing emotion and irrationality to enter decision making.  Many investors are perfectly aware which factors in the fundamental and technical areas are consistent with excess returns, yet consistently fail to capitalize because discipline and consistency are lacking.   Many of the “best laid plans” fall apart amidst market noise and turbulence because too little work has been put into consistent, replicable processes and execution.  

The Fog of War

Like many others, we waited this morning with great anticipation for the release of the 2008 Federal Reserve transcripts.  Considering 2008 proved to be one of the most momentous periods in modern US (and global) history from an economics and market standpoint, it’s fascinating to get a true blow-by-blow view of what policymakers were thinking ahead of and during some of the biggest events during that period.   

What strikes us the most, however, looking through some of the excerpts, is how little many of the Federal Reserve board members and others truly understood or anticipated the deceleration of the economy throughout 2008.  Even as late as September 2008 in the immediate wake of the Lehman collapse, there was some talk about signs of stabilization in the housing market and broader economy.  Many of these highly respected economists couldn’t come close to agreeing whether or not the economy was in recession well into 2008, despite the fact we now know that the recession started “officially” in late 2007.  Some references to potential recession appear in early 2008 from Tim Geithner and Janet Yellen, but they seem to be few and far between.  Only after coincident economic indicators began plummeting in the fall amidst a global credit freeze do we start seeing talk about a recession of historic magnitude.  

Since 2009, we’ve heard many a post-mortem that there “was no way we could have ever anticipated a recession of that magnitude” or “a housing crisis as severe as experienced.”  This got us thinking back not only to those crazy times from late 2007 to early 2009, but to some of the themes we’ve discussed here in the past, namely objectivity, narrative, process, and cognitive biases.  In reality, looking back, the signs for a potential recession, a deep one at that, were apparent as early as late 2006.  Many happened to ignore those signs or explain them away because they didn’t fit a broader narrative.  

For instance by early 2007, leading economic indicators in the US had begun to deteriorate and show classic signs that an elevated probability for recession existed.  Meanwhile, the Treasury yield curve inverted in mid to late 2006, a classic sign of trouble, and remained in that condition for nearly a year.  Policymakers and analysts told us this wasn’t a cause of worry and was the result of a “global savings glut.”  Because the yield curve at the time was a part of the leading indicators index, we were told that the leading economic indicators were being “distorted” and that this time might be different.  Turning to housing, this writer will never forget sitting in a MBA seminar in early 2007 and having David Lereah, the former chief economist of the National Association of Realtors, show up to speak and assure all of us students that a). the fundamentals of the housing market were A-OK, b). even if they are deteriorating, homes were fairly valued, and c). that the underlying demographics were highly supportive of future gains.  These statements were made despite clear quantitative evidence, such as price to rent ratios, price to income ratios, and other data, that real estate prices were far above fair value levels.  Of course, the demographic assertions were suspect.  Several students called him out on this, but he never wavered.  

Again, many of the people driving the policymaking ship at all levels say they were “blindsided” when there happened to be plenty of cause for worry and reflection.  We have to suspect there were plenty of folks in the Fed and elsewhere privately concerned during 2006 and 2007 that the situation was unraveling.  Why didn’t anyone in official quarters speak out or act forcefully on any of the cracking data throughout 2007?  Why were so many willing to explain away increasing signs of deterioration?  These are very intelligent and highly accomplished people.  

We’ll venture a guess.  We’ll blame it on the typical human behavioral biases that doom us as investors and “deciders.”  Groupthink and herding probably came into play.  Very few in an official capacity want to go against the grain or rock the boat, especially when negative news is involved.  This could also be an issue of “loss aversion”, i.e. holding onto losing positions, or in this case losing arguments, in a futile hope that things are going to get better.  Recency bias also certainly played a role and continues to play a role.  Instead of skating to the puck, we place too much value on lagging or coincident data to make decisions.  Going back to the Fed minutes, policymakers seemed to be unwilling to come to the “major recession” conclusion until the data had actually deteriorated, in effect closing the barn doors after the horses had escaped.  The Fed members, like most humans, tend to take the “don’t shoot until you see the whites of their eyes” approach.  Finally, we’ll also guess that biases related to narrative played a big role.  We overemphasize information, stories, and data that confirm our hopes or worldview, and bury information that contradict them.  Naturally, most economic policymakers would much rather operate in a environment that is positive, stable and reasonably worry-free.  Ben Bernanke, Federal Reserve officials, and other top economic policymakers surely didn’t have a fun late-2008 pulling all-nighters, begging Congress for help, and patching the credit system together with duct tape and glue on the fly.  Playing armchair psychologist, and knowing the power of confirmation bias, we can only imagine that many policymakers subconsciously buried developing signs of recession and kept all fingers and toes crossed that everything would move back in the right direction in hopes that the life of the policymaker would remain relatively painless.  

Moving back to markets and investing, there are lessons from this situation that pertain to us as investors, whether individual or institutional.  We’ve been over these several times before, but there worth reiterating again and again.  

• Of course, we should always strive to achieve completely objectivity in our investing approach.  This is easier said than done, though.  Why?
• We are all subject to the same biases as investors that we observed above with some of the smartest policy makers around.  
• When considering new investments we tend to chase recent performance, overemphasize the most recent narrative, and extrapolate trend in a straight line.  At the same time, we ignore evidence that goes against the narrative and assimilate evidence that supports it.  “XYZ stock at $100 is going to $1000 because recent trends X, Y, and Z will continue forever to the moon.  Sure, the stock is trading at 100x normalized earnings, but it’ll grow into the valuation.  Anyway, the only way to value this company is using ‘price per eyeballs,’ and that ratio shows me it’s extremely cheap.”  This happens in reverse.  “XYZ company might be trading at 6x normalized earnings and low valuations across the board, but have you read that series of articles in the Journal about what a stinker this one is?  I can’t let anyone see that I own this black hole.  It was down 50% last year!  The balance sheet is strong, you say, and the new product is showing promise?  Who cares?  Did I mention those articles??”  
• When evaluating existing investments, we consistently engage in loss aversion.  “I know I’m down 50% in XYZ and that the situation has become much worse.  If the stock just gets back to $50, I’ll let it go.”  Months later, XYZ is sold 50% below these levels because the investor “can’t take the pain anymore.”  
• How can we overcome these biases and become better investors?  Discipline and process.  We believe it comes from developing a solid process and sticking to it through thick and thin.  A process can be very complicated or very simple.  A process as simple as rebalancing a portfolio bi-annually or annually or employing other simple asset allocation techniques can make a world of difference performance-wise in the long run.  More sophisticated investors employ tactics such as deep-dish fundamental analysis and technical analysis to manage risk or identify undervalued opportunities.  Whatever the methodology, it’s key to override the part of your human brain that pushes you into buying tech stocks in 1999 with valuations at ridiculous levels, or selling the entire portfolio at the bottom in March 2009.  

Ultimately, as we saw with policymakers and the economic situation throughout 2007, 2008, and early 2009, we as investors have a significant amount of data staring us right in the face telling us that there’s a strong probability of long-term success or failure with a particular investment or course of action.  Yet, we consciously or subconsciously choose to ignore and discard the data.  US markets were trading at over 40x on a CAPE basis in early 2000.  How many were willing to go against the frenzy knowing the evidence was overwhelming that future returns would be subpar?  Numerous stocks were trading in the low single digits in early 2009.  How many were willing to commit capital knowing that historically those valuations have led to outsized returns?  

Yes, hindsight is 20/20.  It’s a cop out in our opinion, though, to always say, “If I’d known X, Y, Z, I would’ve done A, B, and C.”  Many of the best investors in the world aren’t much smarter in the traditional sense than anybody else.  They are, however, disciplined and process-oriented, which allows them to override the emotional pull and tug that leads to poor decisions and take advantage of opportunities before they become “obvious” to everyone else.  Perhaps policymakers in the political realm don’t have that luxury; maybe 2008 would have been just as ugly economically if every public figure at the Fed had expressed concern early in 2007.  In fairness, they operate in a complicated fishbowl.  We do have the luxury as investors, however, of developing these skills and acting on them. 

Sentiment Update: Post-Correction Edition

What a difference a week and a half makes.  The middle of last week, the world was coming to an end.  As of this afternoon, the S&P and MSCI World were near new highs.  What a whirlwind.  

When we published our last monthly chartbook in January, right before the recent correction kicked off, several of our favored sentiment indicators were flashing signs of over exuberance.  Now that markets have sold off and rebounded near levels observed in mid to late January, how has investor sentiment responded?

As with past corrections during this cyclical bull, sentiment has descended back into pessimistic to neutral territory fairly quickly.  Again and again, investor sentiment has been much quicker to tuck tail and run to the pessimistic side when things go awry.  This “wall of worry” and skepticism have provided a positive structural backdrop for continued advances over the past year and a half.  Hopefully that pattern will continue.  

Let’s move to some of the individual sentiment indicators.

First, let’s examine the CBOE equity put-call ratio.  Higher ratios indicate higher bearishness (more put activity relative to calls).  Last month, the put-call ratio had reached the lowest levels since late 2010.  Now with the recent selloff, the 10-day average for the put-call ratio has rebounded to the highest levels seen since last fall.  Granted, as the chart below shows, pessimism levels aren’t near levels seen last summer.  Nonetheless, it’s hard to describe this market at present as being anything close to “wildly exuberant.”  

Next, let’s look at the International Securities Exchange All Equities Index, which shows the number of calls traded for every 100 puts.  In this case, higher levels indicate optimism and lower levels indicate pessimism.  Again, we use the 10-day moving average to smooth out some of the volatility in the indicator.  Prior to the correction, the indicator had reached the highest levels since early 2012.  Since then, sentiment has fallen back below the longer-term average and back within the “pessimism range” we’ve observed since the middle months of 2012.  

On the individual investor side, “neutral” remains the operative word.  We use the Farrell Individual Investment Sentiment indicator, which is a formula based on the weekly AAII bull/bear/neutral survey numbers.  Indicator levels above 1.50 indicate extreme optimism.  Levels below 0.50 indicate extreme pessimism.  Like the others, we use the 10-week moving average.  At the end of December, 2013, this indicator moved as high as 1.15, the highest levels observed in two years.  Since the correction, the indicator has moved down to 0.99, right in the middle of the long-term range.  Note that individual investor sentiment reached bear-market-like pessimistic levels during the summer of 2012 right before markets embarked on the strong uptrend that has continued to this day.  Even with massive returns over the past 18 months, this indicator has never escaped the +1/-1 standard deviation band on the upside.  

Another indicator we keep an eye on is the ratio of 30-day S&P 500 implied volatility (represented by the widely followed VIX index) relative to 90-day implied vol (the VXV index).  Out of whack moves to the upside in this indicator have coincided with short to intermediate term market bottoms in the past.  As we can see below, this ratio actually spiked to the highest levels observed since the market upheaval associated with the European crisis at the end of 2011, which is interesting considering the peak to trough declines associated with the recent correction totaled approximately 5.6% while the peak to trough decline in the S&P 500 was 19% in late 2011 (and over 20% in overseas developed markets).  Not to harp on the issue, but we again see that it doesn’t take much of a move in markets right now to ignite fear.  

Add it all up, and we continue to see a market prone to jump to negative conclusions at the first sign of trouble.  Until we see market enthusiasm jump through the statistical roof and remain steady above those levels (and see market participants remain significantly bullish even in the face of market cracks), we’ll remain reasonably optimistic on the intermediate term prospects for the equity markets.  Yes, valuation is a concern longer-term.  However, the ingredients that combine with overvaluation to mark major market tops haven’t lined up at this point.