Investor Optimism is Reaching Extreme

As it often does, the U.S. stock market trended the complete opposite of what market pundits expected after the election.

Clearly, a Presidential election can be the blame for volatility we saw this year before the election. However, instead of crashing down U.S. stocks regained their previous losses quickly. Along with that, investor sentiment shifted from fearful a month ago to much more optimistic as prices trended up. At this point, investors have probably forgotten how volatile markets were the first part of 2016. Once the losses are regained, they eventually forget the stock indexes were down -12% or more in January and February.

Investors tend to get optimistic (or even greedy) after prices have gone up and then fearful after prices go down.

I am not necessarily a contrarian investor. I mainly want to be positioned in the direction of global markets and stay there until they change. But markets sometimes get to an extreme – increasing the probability of a reversal. At this point, a tactical trader can hedge, reduce exposure, realize profits, or wait until an actual reversal to respond.

My purpose of pointing out these extremes in investor sentiment (fear and greed) is to illustrate how investors’ feelings oscillate between the fear of missing out (if global markets have gone up and they aren’t in them) and the fear of losing money (if they are in global markets and they are falling). Fear and greed is a significant driver of price trends. When stock market investor sentiment reaches an extreme, it often reverses trend afterward.

Indicators suggest that investors are pursuing higher risk strategies and that investor optimism has reached a short-term extreme. I like to use the Fear & Greed Index that is a simple snapshot for anyone to see. Below is the reading as of yesterday as it reached “Extreme Greed.”

cnn-fear-greed-index

We shouldn’t be surprised to see the recent upward price trend reverse down, at least temporarily.

Along with that, we could see investor sentiment reverse from “Extreme Greed” to “Fear” as prices fall.

It’s OK to feel and experience your feelings… if you feel the right feeling at the right time.

Indicators like this can help investors observe how they tend to feel the wrong feeling at the wrong time.

 

To learn more, below are some of my previous observations about sentiment reaching an extreme greed level of optimism.

Investor Optimism Seems Excessive Again

It’s official: extreme greed is driving the stock market

What emotion is driving the market now? Extreme Greed

Extreme Fear is Now Driving Markets

On October 27th I wrote in Fear and Greed is Shifting and Models Don’t Avoid the Feelings that:

The CNN Fear & Greed Index shows investor fear and greed shifted to Extreme Fear a month ago as the popular U.S. stock indexes dropped about -12% or more. Many sectors and other markets were worse. Since then, as prices have been trending back up, Greed is now the driver again. I believe fear and greed both drives market prices but also follows price trends. As prices move lower and lower, investors who are losing money get more and more afraid of losing more. As prices move higher and higher, investors get more and more greedy. If they have reduced exposure to avoid loss, they may fear missing out.

Since global markets declined around August and some markets recovered much of their losses by November, global markets have declined again. Below are charts of U.S. stocks, International stocks, U.S. bonds, and commodities. Even the iShares iBoxx $ Investment Grade Corporate Bond ETF that seeks to track the investment results of an index composed of U.S. investment grade corporate bonds is near -8% from its peak. Small and mid companies U.S. stocks are down more than -20% from their peak. Commodities and emerging countries are down the most.

global markets 2016-01-15_13-59-45.jpg

This all started with investors being optimistic in late October as I mentioned in Fear and Greed is Shifting and Models Don’t Avoid the Feelings. So, it is no surprise that today is just the opposite. As markets have declined investors become more and more fearful. As of now, Extreme Fear is the driver of the market.  Below is the current reading of the CNN Fear & Greed Index.

Fear and Greed Index

Source: CNN Fear & Greed Index 

As you see in the chart below, it’s now getting close to the Extreme Fear levels that often signal at least a short-term low.

Fear and Greed Over Time

Another publicly available measure of investor sentiment is the AAII Investor Sentiment Survey. The AAII Investor Sentiment Survey measures the percentage of individual investors who are bullish, bearish, and neutral on the stock market for the next six months; individuals are polled from the ranks of the AAII membership on a weekly basis. The most recent weekly survey shows investors are very bearish and again, such pessimism occurs after price declines and at such extremes sometimes precedes a reversal back up.

Survey Results for Week Ending 1/13/2016

AAII Investor Sentiment January 2016

Source: AAII Investor Sentiment Survey

I say again what I said in October: This is the challenge in bear markets. In a bear market, market prices swing up and down along the way. It’s these swings that lead to mistakes. Above was a chart of how the Fear and Greed Index oscillates to high and low points over time. Investors who experience these extremes in emotion have the most trouble and need to modify their behavior so they feel the right feeling at the right time. Or, hire a manager with a real track record who can do it for them and go do something more enjoyable.

Fear and Greed is Shifting and Models Don’t Avoid the Feelings

Investors are driven by fear and greed. That same fear and greed drives market prices. It’s Economics 101 “Supply and Demand”. Greed drives demand, fear drives selling pressure. In fact, investors are driven by the fear of losing more money when their account is falling and fear missing out if they have cash when markets go up. Most investors tend to experience a stronger feeling from losing money than they do missing out. Some of the most emotional investors oscillate between the fear of missing out and the fear of losing money. These investors have to modify their behavior to avoid making mistakes. Quantitive rules-based systematic models don’t remove the emotion.

Amateur portfolio managers who lack experience sometimes claim things like: “our quantitive rules-based systematic models removes the emotion”. That couldn’t be further from the truth. Those who believe that will eventually find themselves experiencing feelings from their signals they’ve never felt before. I believe it’s a sign of high expectations and those expectations often lead to even stronger reactions. It seems it’s the portfolio managers with very little actual performance beyond a backtest that make these statements. They must believe a backtested model will act to medicate their feelings, but it doesn’t actually work that way. I believe these are the very people who over optimize a backtest to make it perfectly fit historical data. We call it “curve-fitting” or “over-fitting”, but it’s always “data mining”. When we backtest systems to see how they would have acted in the past, it’s always mining the data retroactively with perfect hindsight. I’ve never had anyone show me a bad backtest. If someone backtests entry and exit signals intended to be sold as a managed portfolio you can probably see how they may be motivated to show the one that is most optimized to past data. But, what if the future is very different? When it doesn’t work out so perfectly, I think they’ll experience the very feelings they wish to avoid. I thought I would point this out, since many global markets have been swinging up and down. I’m guessing some may be feeling their feelings.

The CNN Fear & Greed Index shows investor fear and greed shifted to Extreme Fear a month ago as the popular U.S. stock indexes dropped about -12% or more. Many sectors and other markets were worse. Since then, as prices have been trending back up, Greed is now the driver again. I believe fear and greed both drives market prices but also follows price trends. As prices move lower and lower, investors who are losing money get more and more afraid of losing more. As prices move higher and higher, investors get more and more greedy. If they have reduced exposure to avoid loss, they may fear missing out.

CNN Fear and Greed IndexSource: http://money.cnn.com/data/fear-and-greed/

This is the challenge in bear markets. In a bear market, market prices swing up and down along the way. It’s these swings that lead to mistakes. Below is a chart of how the Fear and Greed Index oscillates to high and low points over time. Investors who experience these extremes in emotion have the most trouble and need to modify their behavior so they feel the right feeling at the right time. Or, hire a manager with a real track record who can do it for them and go do something more enjoyable.

Fear and Greed Over time investor sentiment

Source: http://money.cnn.com/data/fear-and-greed/

Fear is Driving Stocks Down, or is Declining Stocks Driving Fear?

The last time I pointed out a short-term measure of extreme investor sentiment was August 4, see “Extreme Fear is Now the Return Driver“. At that time, popular stock indexes had declined -3% or more and as prices fell, investor fear measures increased.

As stocks rise, investors get complacent and brag about their profits. After prices fall, investor fear measures start to rise.

Since I pointed out “Extreme Fear is Now the Return Driver”, the Dow Jones Industrial Average went on to trend back up 5% by mid September. Below is a price chart for the Dow year to date. I marked August 4th with a red arrow. You can see how the price trend had declined sharply, driving fear of even lower prices, then it reversed back up. Fear increases after a decline and when fear gets high enough, stocks often reverse back up in the short term. They get complacent and greedy after prices rise to the point there are no buyers left to keep bidding prices up, then prices fall. Investors oscillate between the fear of missing out and the fear of losing money.

dow jones stock index year to date

Source: http://www.stockcharts.com

Since mid September, the price trend has drifted back down over 4% from the peak. As you can see, the Dow has made no gain for the year 2014. It is no surprise that investor sentiment readings are now at “Extreme Fear” levels, as measured by the Fear & Greed Index below.

Fear and Greed Index

Source: Fear & Greed Index CNN Money

So, the last time investor fear levels got this high, stocks reversed back up in the weeks ahead. However, it doesn’t always work out that way. These indicators are best used with other indications of trend direction and strength to understand potential changes or a continuation. For example, we commonly observe 4% to 5% swings in stock prices a few times a year. That is a normal range and should be expected. However, eventually prices will decline and investors will continue to fear even more losses. As prices fall, investors sell just because they’re losing money. Some sell earlier in the decline, some much later. You may know people who sold after they were down -50% in 2008 or 2002.  The trouble with selling out of fear is: when would they ever get back in? That’s why I manage risk with predefined exit points and I know at what point I would reenter.

My point is: fear always has the potential to become panic selling leading to waterfall declines. Panic selling can take weeks or months to drive prices low enough that those who sold earlier (and avoided the large losses and have cash available) are willing to step in to start buying again. Those who stay fully invested all the time don’t have the cash for new buying after prices fall. It’s those buy and hold (or re-balance) investors who also participate fully in the largest market losses.  It’s those of us who exit our losers soon enough, before a large decline, that have the cash required to end the decline in prices.

Selling pressure starts declines, new buying ends them.

We’ll see in the weeks ahead if fear has driven prices to a low enough point that brings in new buying like it has before or if it continues into panic selling. There is a chance we are seeing the early stages of a bear market in global stocks, but they don’t fall straight down. Instead, declines of 20% or more are made up of many cycles of 5 – 10% up and down along the way. So, we shouldn’t be surprised to see stock prices drift up 5% again, maybe even before another -10% decline.

Declining stocks drive fear, but fear also drives stocks down.

Let’s see how it all unfolds…

Trend Following Doesn’t Always Mean Crowd Following

“Trading has taught me not to take the conventional wisdom for granted. What money I made in trading is testimony to the fact that the majority is wrong a lot of the time. The vast majority is wrong even more of the time. I’ve learned that markets, which are often just mad crowds, are often irrational; when emotionally overwrought, they’re almost always wrong.”

Richard Dennis  (Famous Trend Follower)

 

Richard J. Dennis, a commodities speculator once known as the “Prince of the Pit,”. In the early 1970s, he borrowed $1,600 and reportedly made $200 million in about ten years.

To learn more about Richard Dennis, no one tells the story like Michael Covel in The Complete Turtle Trader.

 

Extreme Fear is Now the Return Driver

A professional investment adviser recently passed along some materials and asked for my opinion about a “tactical model” offered by another money manager. I was surprised that they expect great results from their model when it said something like:

“As investors become more risk-averse, the model becomes more defensive and vice versa.”

Let’s consider that for a moment.

As investors become more risk-averse, the model becomes more defensive. When investors become more risk-seeking, the model becomes more offensive.

That surprises me because investor sentiment is usually used as a countertrend indicator, not as a trend following indicator. Investors often get overly optimistic after prices have trended up and investors get more afraid after prices have trended down.

They went on to say they also use economic indicators as their signal to increase and decrease exposure. I am always concerned when I hear of someone using anything other that the direction of the price trend itself. Other indicators like credit spreads or perceived risk premiums are derivatives of price and it’s the directional movement of the price trend itself we really want. If the price gains 5%, we make money. If the price loses 5%, we lose money. If the price does nothing and the ratio or spread you rely on goes up or down, it did nothing for you. If you use something that is a derivative of the price itself, you have the potential to stray far from the price trend itself.

All blow-ups in history started that way.

Investor sentiment is usually wrong. It isn’t something I’d want to follow. If anything, I’d want to do the opposite of investor sentiment when it reaches an extreme. I occasionally point out my observations when investor sentiment reaches an extreme. When I do, I’ll highlight a simple sentiment gauge that is publicly available on the CNN Money website. Now, that gauge doesn’t actually have a signal that says when it has reached an extreme. It’s just a gauge to swings from one extreme to the other and spends a lot of time in between. It isn’t what is telling me to share my observations – it’s not my signal. I have other systems for actually doing that, but my systems often coincide with extreme readings in the Fear and Greed Index.

investor sentiment fear driving stocks

source: Fear and Greed Index

 

As of Friday, fear is driving stocks. A few weeks ago I pointed out “It’s official: extreme greed is driving the stock market”. Prices had been rising and investors became more and more optimistic. Stocks have now fallen about 3 – 4% and investor sentiment quickly shifted from “Extreme Greed” a few weeks ago to “Extreme Fear” now. The stock market had gone months without a 1% move, so a -2% down day got their attention.

stock market decline investor fear

source: http://www.stockcharts.com

Investor sentiment isn’t necessarily and indicator I use to increase and decrease exposure, but instead one that is useful to help investors understand problems in their behavior. If you find yourself getting more aggressive after prices have already made a big move, or scared after price declines, you may find it useful to monitor the Fear and Greed Index to help adjust your behavior. That money manager may be one of them.

If anything, you may find increasing and decreasing exposure to risk is best done opposite of sentiment extremes, not along with it. Investor sentiment is usually wrong, not right. Extreme fear occurs at lows, extreme greed at highs.

 

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