Is fearfulness finally giving way to greed?
Following Warren Buffett’s stock-market investing formula of being fearful when others are greedy and greedy when others are fearful sounds easy enough. The problem, however, is that it can be hard to discern whether investors are greedy or fearful or somewhere in between.
Past surveys have indicated that investors often say they are fearful but still act as though they are very optimistic.
The current bull market, which entered its ninth year in March, has arguably been one of the most hated, and that longstanding skepticism has been credited as a force behind its longevity. The S&P 500 SPX, +0.10% climbed even as investors remained skeptical about the economy, earnings and, more recently, lofty valuations. The index was in record territory Monday, up 0.3%, and has rallied 13% since the end of 2016.
But as the main indexes continue to hit records, investor optimism has started to rise as well. So is some fearfulness justified?
Analysts at Bank of America Merril Lynch, in a recent note, said that sell-side optimism levels—a contrarian indicator—remained at six-year highs by the end of September.
The Merrill research team’s model looks at the consensus of sell-side optimism and pessimism levels in relation to the 15-year rolling average to see the change in trend. A reading above the red line is a “sell” signal and a reading below the green line is a “buy” signal. According to this model, the sentiment, while improved, remains below the “danger zone,” and therefore implies positive returns in the near future.
On the other hand, another model that instead uses a four-year rolling average, instead of 15, is flashing a clear sell signal, they said.
“Typically, when four-year rolling sentiment reaches highs, the average 12-month forward return is very weak—less than 1%, and there is a 49% chance that it will be negative,” said Dan Suzuki, equity and quant strategist at Bank of America Merill Lynch.
“In isolation, this particular indicator does not have much weight, after all, statistically it’s a coin flip that it would be negative. But taken together with all the surveys showing improving optimism, it suggests that we should be cautious,” Suzuki said.
Such view is in line with Bank of America’s macro analysts, who last week said that the reason to be bearish on U.S. stock is that there is no reason to be bearish.
“From the economic environment point of view, we’ve had a prolonged time that was ideal for stocks: interest rates were low, volatility was low and we saw improving earnings growth. But all of that is changing now. Interest rates are rising and earnings peaked in the first quarter,” said Suzuki.
“From the sentiment point of view, investors moved out of skepticism and are solidly in optimism territory, which historically has been less bullish for stocks,” Suzuki said.