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Is the Crowd’s Cheery Mood Reason to Fear the Rally’s End?

Michael Santoli

On Wall Street, it typically pays to fear the cheer.

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When a broad enough selection of professional and individual investors starts to feel happy about the stock-market outlook, it often means risks are being overlooked, buyers have done their buying and the market is due for a rest or retreat.

Synthesizing the present investor mood through a multitude of surveys and statistical gauges of behavior and emotion, it’s fair to say investor optimism is climbing toward the upper end of its long-running range, a caution flag that implies the tape is vulnerable to a pullback, or at least a stall. Yet the crowd’s contentedness isn’t yet wildly out of step with the market backdrop of the indexes stretching to a five-year high.

Buttressing this equivocal conclusion, such long-tenured indicators as the weekly polls from the American Association of Individual Investors (AAII) and Investors Intelligence both show bullish feeling rising toward the highest readings of last year - but not quite matching them.

The AAII split between self-professed bulls and bears this past week closely matches those of mid-March 2012, which reflected a very strong start for stocks last year and came a few weeks before the S&P pushed to a four-year high, ahead of the spring-summer correction turning things nasty until August.

Fear and greed

CNN Money maintains a weekly Fear & Greed Index made up of several “real money” measures of risk appetite, including stock momentum, junk-bond pricing and options activity. It scaled its way into “extreme greed” territory these past two weeks. In recent years such a move has coincided with short-term rallies running their course.

The CBOE Volatility Index, a measure of prices for protective index options, dropped to a post-June 2007 low Friday of just above 13, prompting plenty of chatter about worrisome mass complacency. For sure, it reflects a becalmed market that would not easily absorb even a minor shock. Yet again, its absolute level in itself is not far out of line with general market conditions at the moment.

Jason Goepfert, founder of www.SentimenTrader.com, tracks a multitude of investor-attitude signals, always placing them in the context of how much optimism one should expect to see given how the market itself has been performing. Late last week, taking note of the accumulation of upbeat readings, he concluded that short-term pullback risk is elevated but otherwise there are few clear run-for-the-hills indicators.

“Really, the only negatives I'm seeing [from a contrary sentiment point of view] are in the one- to three-week time frame,” Goepfert says. “After that, it looks OK in terms of sentiment not being excessive.”

A new sentiment tool

Online broker TD Ameritrade last week entered the sentiment-tool fray by launching the Investor Movement Index, a monthly reading on the risk-taking behavior of its own active trading clients. In December it showed the most aggressive trading posture since mid-2011, though it’s interesting that this was lower than the early-2011 record high, a time when many commodities and global stock markets peaked.

Goepfert, who evaluated the IMX, says, “I'm all for real-money indicators, and their methodology seems sound. It's pretty apparent that the accounts are trend-following, with a slight delay, which is typical for retail-oriented sentiment." It’s likely to serve more as a coincident indicator of retail investment postures, rather than a timely tactical trigger.

Last week some $22 billion in new money entered equity mutual funds, about $13 billion of it through exchange-traded products, according to Lipper and EPFR Global – the second-largest weekly net inflow ever. Several comparably strong weekly rushes into equity funds in recent years have come not far from interim peaks, though a couple passed without auguring any market trauma.

There may be some one-off factors that made this grab for stock funds so pronounced. Companies distributed tens of billions in special and accelerated dividends in December, and the public likely held back from reinvesting them until the “fiscal cliffhanger” was forestalled Jan. 1.

A more lasting shift?

It’s not knowable -- even as it’s widely predicted -- whether this represents a more lasting shift of the public’s cash commitment to stocks, after years of largely abstaining from equities in favor of bonds and cash. This “asset reallocation” notion underpins many market watchers’ bullish calls for 2013. Whether it occurs in any pronounced way is by no means assured.

Doug Ramsey, chief investment officer of Leuthold Group, points out (only slightly facetiously) that stocks are finally expensive enough for retail investors to find them attractive.

His firm calculates that, since 1980, months with net inflows into U.S. stock funds have occurred when the “normalized” price-to-earnings ratio (a conservative metric using the past decade’s average earnings) has averaged 20. That’s right at the current normalized P/E. In months with net outflows, stocks were cheaper, with the P/E averaging between 16 and 17. This is more proof that the public tends to arrive a bit late in a bull market.

Staying attuned to sentiment cues has become an exceedingly popular exercise in the bull market that began nearly four years ago. In fact, the effort to justify one’s market view by claiming “everyone” is positioned the opposite way has become almost a cliché, harkening to the paradoxical Yogi Berra assertion, “Nobody goes there anymore – it’s too crowded.” A startup firm is actually launching a trading platform utilizing sentiment hints gleaned from Twitter messages.

While the S&P 500 index has more than doubled since March 2009, its path has included scary, switchback declines of between 9% and 20% in each of the past three years. Near those tops, a generally skeptical, stock-shunning public began warming to stocks once the market had been strong for some months, offering contrarians a clue that most of the good news was already embraced by the market.

If the current run to new post-2007 market highs turns into a more lasting and ebullient “liftoff” phase, exciting the masses about stocks again, then perhaps it will be necessary to upwardly revise the boundaries of what sentiment levels represent “too bullish” or “too bearish.”

It’s way too soon, though, to assume we’re in for the kind of environment where widespread cheer is to be welcomed.