February 25, 2013 7:36 pm

Equities: A sentimental wager

A small bull and a bear (R) symbolising the up and downward trend in stockmarket movements stand in front of a display panel at the stock exchange in Frankfurt, Germany, 29 June 2011. This Wednesday 29 June 2011, the Greek parliament in Athens had passed the latest austeritiy package which was anticipated with great interest, and which would make way for the Greek government to receive further international financial aid in billions of euro©Photoshot

Gero Bauknecht is worried. His family made a fortune from cooking equipment, but he’s much more concerned about the temperature of the market. Right now, he fears, it is overheated.

From his pleasant office overlooking Lake Zurich he began protecting the family money two weeks ago, selling shares and buying insurance against a rout in the markets using put options.

Panic or euphoria: six ways to measure the market

Panic or euphoria: six ways to measure the market

“A year ago the environment was quite bearish, and nobody wanted to be invested [in the market],” he says. “Now it seems to me the complete opposite. Sentiment looks very extended. Everybody seems to be bullish.”

He is far from alone. Animal spirits are back in a big way, and it has many worrying that the market is becoming over-exuberant.

The Dow Jones Industrial Average is flirting with 14,000 for the first time in five years, eurozone bank shares have jumped two-thirds in six months, and even the global market deadbeat of Japan is performing. Perhaps most positive of all, the little guy is being tempted back into shares: equity mutual funds are attracting money again, with net sales this year the strongest since before the crisis, according to EPFR Global.

Contrarians fear all this good news is a sign of bad news just around the corner.

“There are a lot of measures that tell us markets are overbought at this point,” says Philip Saunders, head of multi-asset funds at Anglo-South African fund manager Investec. “Nothing goes up in a straight line.”

Franz Wenzel, head of investment strategy for France’s Axa Investment Managers, advises reducing exposure to shares, even though he thinks they are still a good long-term bet. “The stars are still aligned for equities,” he says. “It’s very similar to [April/May peaks in] 2011 and 2012: there’s too much optimism. The risk of a setback is not negligible.”

What has these and many other investors spooked is the counter-intuitive concern that the rest of the market is becoming overconfident, even complacent. All believe that signs of froth in the market are a signal that it is time to get out or at least to reduce exposure.

A small industry has grown up to serve sentiment-watchers by trying to measure optimism, in an effort to time purchases and sales. The aim is to measure when investors are feeling particularly confident, on the grounds that at that point they are more likely to become fearful than even more confident. Equally, they hope to spot moments when everyone else is at their most depressed, when the market is a bargain.

. . .

This lesson was driven home in 2000 when the dotcom bubble burst. Investors could hardly have been more positive, cheering on companies such as Pets.com all the more the faster they burnt through their cash. But it was only after the 2007 crisis that measuring sentiment really came into its own. Back in the late 1990s, optimism was so overheated it began to be taken for granted. After the financial crisis, many more investors began to think that timing the peaks and troughs of the market depended on spotting when fear or greed were dominant.

“It’s been giving pretty good steers about what side of the trade you want to be on, says David McBain, who produces sentiment measures at Absolute Strategy Research in London. “There’s been a lot more interest in the past couple of years as a result.”

There are lots of ways to take the temperature of investors. They break down into three broad categories: measures of action in parallel markets, particularly in options; measures of investor positioning, such as flows into mutual funds, mutual fund holdings of cash or hedge fund exposure; and surveys of how investors and their advisers feel.

Matthew Merritt, head of multi-asset strategy at Insight Investment, says sentiment is a vital guide to how investors are positioned. “What you’re trying to do is build up a picture of market psychology,” he says. “You’re really trying to understand where there are crowded trades and where assets have moved to such a level [up or down] that there’s a shift in the risk-return trade off.”

In other words, when investors are excessively bullish, a setback on fundamentals such as profits or the economy could hit doubly hard as disappointment adds insult to the real-world injury.

Equally, when the market is deeply gloomy, good news is so unexpected it can have far more impact than in normal times.

Exactly this effect was seen last week, when surprising signals from some US Federal Reserve policy makers and dire economic data out of Europe led to a brief bout of turmoil. But the market has resumed its rise, even overcoming the UK’s loss of its triple-A credit rating.

Mr Merritt is concerned that the market looks high and has been adding protection to cover the risk of a fall. But he says sentiment measures are not uniformly sounding alarm bells: “On some of our measures we’re flashing amber if not red but in other cases that’s slightly less clear cut.”

A vital question for anyone thinking of changing their position because of something so ephemeral as sentiment is whether the measures actually work. Here, there are plenty of sceptics – and the evidence is mixed, at best.

. . .

Matthew Sargaison, chief investment officer of computer-driven hedge fund AHL, says the evidence is “relatively weak”. Rather than trying to spot market peaks and troughs in advance using sentiment, AHL rides the trend until it appears to be ending. That might mean some losses if the market reverses suddenly but it also avoids the danger of getting out of a trend too early. As Mr Sargaison says, “bubbles burst when they burst”.

Put another way, sentiment can always become more bullish or more bearish. No matter how extreme sentiment seems to be, levels that have been reliable indicators in the past can be surpassed – as 2000 showed for extreme froth and 2009 for deep gloom.

After Lehman Brothers collapsed in 2008, some of the favoured indicators of sentiment-watchers became extremely depressed, a clear buy signal. They continued to get worse and worse for months, as the market fell still further.

John Stopford, head of fixed income at Investec, says this is part of the problem of using sentiment – and one reason not to rely on it on its own.

“The danger is you’re always too early,” he says. “Things can get more frothy before it blows.” He also highlights the difficulties of measurement: “Individually the sentiment indicators are all quite flaky. You have to build a picture out of a variety of indicators.”

Pretty much every investment bank now offers some sort of composite sentiment guide as part of its strategy advice, given pithy names such as Citigroup’s “panic/euphoria” model – currently close to euphoria, a worrying sign – or BNP Paribas’s “love-panic” index, now flashing warning signs in both the US and Europe.

Academics and computer-driven fund managers are less convinced. Andrea Frazzini, a former academic now at AQR Capital Management, a quantitative manager in Greenwich, Connecticut, has found good evidence of sentiment working as a contrarian indicator for individual stocks, with “hot” stocks with lots of trading activity tending to underperform. But it is harder to prove at the level of the market.

“We do have some evidence that high sentiment does tend to lead to lower returns,” he says, but there is too little data to be sure. “We only have a few decades to work with and there’s only been a few times when sentiment is very high or very low.

“High sentiment periods are not great for future market returns. But if you look at it in a formal way it’s very hard to reject the hypothesis that sentiment doesn’t really have any effect on aggregate market returns,” he says.

“Each one of these measures is so noisy; as a single measure almost all of them will be irrelevant. But if you take a combination of them it’s going to become more useful.”

On the outskirts of Zurich, Mr Bauknecht is braced for a 10-15 per cent correction before shares begin to rally again. But like many others he accepts sentiment comes with no guarantees. As well as his conventional preparations, he has a small bet against Australian banks, which he thinks would be hit very hard if equities suffer a serious setback, offering outsize returns at a cost he can just write off if the rally resumes.

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Panic or euphoria: six ways to measure the market

AAII bull-bear ratio

Nothing illustrates the flakiness of some sentiment measures more than the weekly survey by the American Association of Individual Investors. Widely used as a guide to the proportion of bulls and bears in the market, it involves sometimes fewer than 100 self-selected investors reporting their mood. Yet its long history and broad accuracy – super-bullish at market peaks, uber-bearish when the market bottoms out – has made it a favourite.

Investors Intelligence

There are some very shrewd writers of investment newsletters (Jim Grant of Grant’s Interest Rate Observer is an example). Taken as a whole, newsletters capture the feeling in the market. Investors Intelligence categorises each newsletter as bullish or bearish; the spread between the two shows when writers are becoming emotionally attached to the market.

Futures market positioning

Many investors try to copy what the “smart money” is up to. They would do better to watch it as a contrary indicator, preparing to do the opposite. Positions in S&P 500 derivatives (not the e-mini) offer a handy guide to how sophisticated traders feel about the market. The net positioning shown in the chart can be used to test whether they are too optimistic or pessimistic.


Equity put/call ratio

The options market offers investors the chance to buy insurance for their portfolios or speculate on future gains. The ratio between put options (which make money if the market falls) and calls (which profit from rising markets) is an immediately-available guide to how relatively sophisticated investors feel. When it becomes very high, investors are extremely cautious, when very low, they feel no need for insurance.

Combined measures

Lots of consultancies and investment banks produce combined measures, all constructed somewhat differently. Shown here is one, from Absolute Strategy Research, which combines the different investor surveys into a single poll of polls. At the moment it suggests investors feel dangerously sanguine.

Investment bank equity weighting

The model contrarian would only invest in things that made them feel physically sick and only sell when convinced they should buy more. Merrill Lynch strategists measure recommendations from the rest of Wall Street’s strategists, and suggest doing the opposite. At the moment the Street’s strategists have a low weighting in equities. Merrill sees this as a bullish signal for shares.

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