People typically share their opinions based on their own personal observations of what they see and hear going on around them.

What we believe is always true, for us.

An advantage of a quant, or quantitative analyst, is the ability to study the data and trends to observe what is really doing on.  Data science is an interdisciplinary field that uses scientific methods, processes, algorithms, and systems to extract knowledge and insights from structured and unstructured data. Then, we get to see how it compares to our own unique observations.

A friend of mine who happens to be a business broker helping people buy and sell businesses commented he thinks the next big recession will be caused by consumer debt. As we discussed it a few minutes, his opinion was based on his own observation that it seems the people around him are living “high on the hog” as we say it down South. In other words, people are taking on heavy debt and spending what they earn rather than saving and investing.

I can see why he may perceive it that way if your neighbors have a fleet of newly leased luxury cars in the driveway and seem to be taking vacations beyond what you believe they can afford. In some cases, if not many, it may be true their personal debt to income ratio may be maxed out. They may be buying cars, boats, and trips instead of saving and investing their excess earnings.

But, everything is relative.

Sometimes when things are good people want to take some extra chips and reward themselves. In fact, some of the greatest rainmakers I have known do this very thing. Many hard-charging producers of wealth also enjoy the rewards from their work.

Some of us get as much satisfaction from seeing our investment accounts grow from investing our excess earnings. Maybe we are more Introverts, so motivation comes from within, rather than impressing others. But that doesn’t mean we don’t enjoy the fruits of our labor. As everything is relative, we may be only eating a slice of an apple from a cart of dozens. But, for those who don’t have dozens of apples, it may seem more.

It’s an illusion of asymmetric insight, which is a cognitive bias whereby people perceive their knowledge of others to surpass other people’s knowledge of them.

Others are more extroverted and willing to spend all of their money in the present moment, rather than plan for the future. In this case, they may spend their earnings as fast as they get it, so there is no “excess” earnings to worry about. I suppose if you spend it all, you’ll have less stress about investing it, but you’ll be on the treadmill forever. While those who spend all of their earnings don’t have to concern themselves with the capital markets and investment management, they may not sleep well at night with all the uncertainty the lack of a secure future can bring. But, some of them may not think that far and not worry about it at all.

Consumer sentiment also has a role in how we all spend our money. When people are optimistic about the future, we are more willing to spend. There are infinite factors that drive sentiment, rational or not. For example, with a great credit score, you could get a car loan at 2% for years and such a low rate of cost to borrow may be more enticing to buy new cars. Even wealthy investors will take advantage of low rates since it doesn’t require withdrawing from investment funds and the borrowing cost is minimal. We can say the same for mortgage rates. The wealthiest of investors probably achieved it with some level of leverage. For example, business owners may use debt early on to grow their company and then when they sell it, it may either be debt-free or the net capital gain is much higher than it would have been without using the leverage to grow. Some use of debt or leverage can be good and it’s even essential in some areas such as real estate to maximum return on equity.

So, on the topic of debt, rates, savings, and such, here are some charts of the data.

First, let’s look at consumer sentiment. The US Index of Consumer Sentiment from the University of Michigan tracks consumer sentiment in the US, based on surveys on random samples of US households. The index aids in measuring consumer sentiments in personal finances, business conditions, among other topics.

Take out the 1999 euphoric period and consumer sentiment by this measure is about as high as it gets.

Historically, the index displays pessimism in consumers’ confidence during recessionary periods, and increased consumer confidence in expansionary periods. So, in the next chart, we highlight recessions in gray.

Does consumer spending match consumer sentiment?

As consumer sentiment is relatively high, spending as measured by US retail sales is at an all-time high. I note some divergence since around 2017 as sentiment has remained elevated but cycling up and down mostly above its average as retail sales trends up.

Employment and interest rates are a drive of these global macro trends. I observed in Employment, Coronavirus, it’s just the market, doing what it does… that unemployment is at historic lows. When most people who want to work are working that’s probably helping consumer sentiment. Gotta love such low unemployment! But, as a risk manager, we also use it as a reminder of situational awareness since nothing lasts forever.

What about the savings rate?

This is one of my favorite non-market global macro trend charts. Total savings is trending up.

Aside from employment, some other drivers of consumer sentiment are probably the trend and level of retail gas prices, auto loan rates, credit cards, home equity lines of credit, and mortgage rates. While we much prefer to see our fellow American’s use less debt, relatively low rates make borrowing more attractive. Again, some of the wealthiest families may even borrow at low rates and keep their capital invested. So, debt isn’t just borrowing because they can’t afford it otherwise.

The US Retail Gas Price is the average price that retail consumers pay per gallon, for all grades and formulations. Retail gas prices are important to view in regards to how the energy industry is performing. Additionally, retail gas prices can give a good overview of how much discretionary income consumers might have to spend.

We’ve enjoyed some relatively low gas prices for the past five out of ten years. You may have noticed it at the pump or observed the lack of gas price headlines.

I first showed the more recent period to point out we tend to have recency bias, as we weight the most recent experience the most. It’s a “what have you done for me lately” kind of mindset.

Next up is the longer-term trend in retail gas prices. I marked the high and low along with the average gas price going back to 1990.

While the retail gas price has been elevated above average, it’s far from the highest levels of the past.

Is there really causation here between the price of gas and consumer sentiment?

There has been a negative correlation between the price of gas and consumer sentiment, so yes. I’ll say they are related the past decade in that a down-trending gas price helped drive up consumer sentiment.

I’m going to save some interest rates for another observation, so next up is my favorite chart.

The Federal Reserve Board’s Household Debt Service and Financial Obligations Ratios convey how much of US household income is being spent on repaying debts and mortgages. It includes data specific to renters and homeowners. The homeowner data includes income spent on automobile lease payments, property taxes, and homeowner’s insurance.

US Household Debt Service as Percent of Disposable Income and US Household Consumer Debt Service as a Percent of Disposable Income are both at relatively low levels. Debt service is about as low as it’s been. Consumer debt service is below average. 

You probably want to invest in stocks right now, I bet.

If you are already invested in stocks, you probably want to be more aggressive in investing in stocks. Maybe it’s selling bonds to buy more stocks, or investing that extra cash, or something really aggressive like adding leverage or buying more risky stocks.

I believe this because investor sentiment is dialed up and 2020 started out about as enthusiastic as it gets. Well, and we’re getting calls from people wanting to invest.

The Fear & Greed Index is driven by seven different investor sentiment indicators. If you’re an investor, I encourage you to use it as a gauge for your own enthusiasm and panic.  When you feel one way or another about the future direction of the stock market, check the indicator to see what emotion is driving the stock market now.

Avoiding costly mistakes is essential in money management, so if we can help you avoid buying too high and then tapping out at the lows, that’s an edge. That’s the behavioral counseling we do; investor behavior modification. It’s one of the main observations I share here. If nothing else, I hope I can help you avoid making costly emotional decisions as many investors do.

The Options Speculation Index measures speculative call buying as a % of total option activity. Right now, it shows the options market bought to open 21.6 million speculative call options, the most ever, according to SentimentTrader. The previous record was 19.7 million during the week of Jan 26, 2018. The total bullish/bearish volume was the most since March 2000. This is extreme.

Investors sentiment trend to follow price trends, so investors or trend followers.

After prices trend up, investors get more bullish, expecting the gains to continue.

After prices trend down, investors get more bearish, expecting the losses to continue.

So, it isn’t a surprise to see this level of enthusiasm, considering the stock index is at an all-time high.

The AAII Investor Sentiment Survey is a another gauge that offers insight into the mood of individual investors. Each week, AAII asks its members a simple question: Do they feel the direction of the stock market over the next six months will be up (bullish), no change (neutral) or down (bearish)? They refer to this question as the AAII Sentiment Survey. Since they started polling members in 1987, our survey has provided insight into the moods of individual investors.

Pessimism among individual investors about the short-term direction of the stock market is at a six-week high. The latest AAII Sentiment Survey also shows lower levels of bullish and neutral sentiment. Below is a chart I drew of the % Bearish sentiment from the survey with a line marketing its long-time average. Investors are not bearish, as the level is at its long term average. So, this gauge doesn’t match the Extreme Greed of the Fear & Greed Index. 

The % Bullish is actually below average by this measure. Bullish sentiment, expectations that stock prices will rise over the next six months, fell 4.1 percentage points to 33.1%. The historical average is 38.0%. Optimism has been below this average during 41 out of the last 52 weeks.

AAII guesses:

Ok, so this isn’t anything new. I just discussed it last week in “Investor sentiment signals greed is driving stocks as the U.S. stock market reaches short term risk of a pullback.” The sentiment indicators keep confirming the same signal: that investors are very optimistic about future gains.

It’s the kind of sentiment we often see before a decline.

The Fear & Greed Index is a simple combination of seven different indicators that are considered investor behavior measures. It includes the Put/Call Ratio, the net new 52 week highs and lows, stock price breadth, market momentum, the yield spread between junk bonds and investment-grade, and market volatility.  It’s a useful gauge to monitor against your own sentiment and behavior. The Fear & Greed gauge remains at a high level, signaling “Extreme Greed” and excessive optimism.

Just as the stock market cycles up and down over time, so does investor sentiment. In fact, I believe investor sentiment oscillating between fear and greed is what drives stocks in the short run.

We measure this investor behavior with these different indicators. For example, the number of stocks hitting 52-week highs exceeds the number hitting lows and is at the upper end of its range, indicating extreme greed. The S&P 500 is 4.90% above its 125-day average is another above the average than has been typical during the last two years and rapid increases like this often indicate extreme greed.

The Put/Call Ratio shows during the last five trading days, volume in put options has lagged volume in call options by 50.13% as investors make bullish bets in their portfolios. This is among the lowest levels of put buying seen during the last two years, indicating extreme greed on the part of investors.

Stocks have outperformed bonds by 4.50 percentage points during the last 20 trading days. According to the Fear & Greed Index, this is close to the strongest performance for stocks relative to bonds in the past two years and indicates investors are rotating into stocks from the relative safety of bonds.

Junk bond demand shows investors in low-quality junk bonds are accepting only 1.84% in additional yield over safer investment-grade corporate bonds. This spread is down from recent levels and indicates that investors are pursuing higher risk strategies.

Investors tend to feel the wrong feeling at the wrong time as they oscillate between the fear of missing out and the fear of losing money.

Another useful gauge I follow is the AAII Sentiment Survey. Since 1987, AAII members have been answering the same simple question each week. The results are compiled into the AAII Investor Sentiment Survey, which provides insight into the mood of individual investors. Today’s AAII Sentiment Survey shows Investors are optimistic again. Optimism is above 40% on back-to-back weeks for the first time since August 2018.

The investor misbehavior of thinking, feeling, and doing the wrong thing at the wrong time doesn’t just include individual investors, but also many professional investment managers.

‘Fear of missing out’ triggers huge fund manager shift from cash to stocks,

The latest Bank of America Merrill Lynch investment fund managers survey shows fund manager cash levels are lowest in six years  and

“Investors are experiencing Fomo—the fear of missing out—which has prompted a wave of optimism and jump in exposure to equities and cyclicals,”

According to ‘Fear of missing out’ triggers huge fund manager shift from cash to stocks, Bank of America Merrill Lynch says:

The survey of 230 managers running $700 billion of assets found cash levels dropped 0.8 percentage points to 4.2%, the biggest monthly drop since Nov. 2016 and the lowest cash balance since June 2013.

Like individual investors, many investment managers also oscillate between the fear of missing out and the fear of losing money. This may be especially true for relative return mutual fund type active managers who aim to beat an index benchmark. If they are underperforming their index after an uptrend, they may feel the fear of missing out and increase their exposure. If they lose as much or more on the downside, they may tap out after the fact to avoid further losses.

An objective of absolute returns necessarily requires seeing, believing, and doing things differently as an independent thinker.

As investors seem to be taking on more risk, I see indications that stocks may be near a point of buying exhaustion. Keep in mind, these investor sentiment surveys are on a lag. It was probably this very optimism that pushed stocks to this higher level.

If there is enough enthusiasm left to keep driving prices higher, the uptrend will continue as long as optimism prevails. If instead these indicators and surveys are a signal of buying exhaustion, we’ll see prices fall at some point from here.

I focus on these extremes in investor sentiment.

So, it may be a good time to reduce or hedge off some risk.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

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 advice to buy or sell any security. Securities reflected are not intended to represent any client holdings or any recommendations made by the firm. Any opinions expressed may change as subsequent conditions change.  Do not make any investment decisions based on such information as it is subject to change. 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 is 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 use of this website is subject to its terms and conditions.