Equity markets are a constant discounting mechanism. The prices of individual stocks reflect the collective opinion of thousands, if not millions, of investors at a certain point in time about a company’s worth and the value of their future earnings streams.
Many of those opinions are based on an analysis of a business’ fundamentals: revenue, profit margins, cash flow and debt levels, to name just a few. This type of bottom up analysis helps fund managers determine whether a stock is trading above or below the price they believe it would command in an acquisition.
Stocks priced below fair value can provide an attractive buying opportunity, while those priced at higher multiples are better held or trimmed at a profit.
For an aggregate view on the valuation and direction of the overall market, we like to examine measures related to investor sentiment.
As market indices keep reaching new highs, a question we keep hearing being asked is how much longer the current eight-and-a-half-year bull market in US stocks will run.
The only way you perpetuate bull markets is to have periodic setbacks. As long as fear is present on small- to medium-sized declines, that is a sign the bull market still has room to rise.
Snapshots of investor psychology, such as the American Association of Individual Investors Investor Sentiment Survey, give us a good idea of whether stock prices are getting ahead of themselves or if they have room to move higher.
Last year’s market correction is a good example of what sentiment can tell us about stock valuations.
We made a call in February 2016, becoming bullish following a waterfall decline, capitulation rally and the retesting of lows that we believe represented a major market bottom. We became more constructive on equities due in part to extremely negative investor sentiment.
Severe levels of bearishness are often a contrarian indicator and both the AAII survey and the Investors Intelligence Advisor Sentiment Survey, which reflects the market views of over 100 independent investment newsletters, were flashing caution. The AAII survey had just registered two of its lowest bullish sentiment readings in the last 20 years, while the Investors Intelligence reading had fallen to levels last seen during the sell-offs of 2009 and 2011.
While not at the extreme levels of early 2016, recent survey readings suggest investors have become more bearish again. The percentage of bullish investors in the AAII survey fell to its lowest point in a year in August.
Meanwhile, the Investors Intelligence “bull-bear spread” has dropped by about 25 per cent in the last month, indicating that the risk of an overheated market is lessening. In addition, the number of bulls in the survey recently fell to their lowest level since prior to the election of President Donald Trump.
Another indicator of investor attitudes toward stocks is volatility. The Vix index has become a popular way to measure the severity of daily price swings. Higher levels of volatility are typically associated with market stress, while the lower levels of volatility we have experienced for most of the last five years suggest a lower risk market environment.
We are concerned that the stubbornly low levels of volatility have caused investors to become complacent about the risks of investing in stocks. Volatility has been spiking higher in the last month due to rising geopolitical risks and this type of action is a healthy sign that risk is once again being acknowledged.
While we believe that parts of the US stockmarket are crowded and expensive, these readings on investor sentiment and volatility suggest that enough opportunities remain in the overall market to extend the current uptrend.
Evan Bauman is portfolio manager of the Legg Mason ClearBridge US Aggressive Growth fund