Investing

Sentiment: On the Fence

There are two main competing schools of thought that attempt to explain, or account for, stock price movements. The first is the Efficient Market Hypothesis, which in its simplest form theorizes that share prices reflect all available information that might impact a stock price one way or another. As a result, consistently generating returns greater than the market is not really possible. Please note there are different degrees of efficiency within this theory but we’re just touching on the most basic premise.

The other competing school of thought is behavioral finance, which theorizes that stock market participants (humans) don’t always act rationally which leads to mispricing of stocks. This mispricing creates an opportunity for someone else to exploit and to generate an above market return. Whether this exploitation can be sustained over time is debatable, but evidence suggests that very few market participants are able to consistently exploit mispricings in such a way that generates above market returns, at least net of management fees.

While we could debate the merits of each theory, we don’t have anything new to add to the discussion. Both have meaningfully contributed to our understanding of stock price movements. Both offer compelling theories and evidence that together provide a more comprehensive explanation of stock price movements than either in isolation, in my opinion.

Sentiment

Using sentiment as an indicator falls under the behavioral finance umbrella. Sentiment indicators have been used by institutional and individual investors for years to help gauge the overall mood of stock market participants. The rationale being that investor mood can provide insight into future stock price movements. For example, if the majority of investors are bearish (negative) one might expect stock price movements to be negative going forward. However, sentiment indicators sometimes are reactions to what has already happened and can serve as contrarian indicators. In the case of a majority of bearish investors, future stock price moves may end up being positive as all the negative movements have already occurred and survey participants are responding based upon what has already happened, not what is likely to happen. This is called recency bias and likewise falls under the behavioral finance umbrella.

AAII

The American Association of Individual Investors (AAII) publishes a weekly sentiment survey that gauges participants’ expectations for stock market movements six months out. The survey is a good gauge of the mood of individual investor. In particular, it offers insight into how those investors might be positioning their portfolios right now in anticipation of their future expectations being met.

The most recent survey shows the majority of participants are still in the neutral camp although an increasing percentage, on the margin, are becoming more bullish. Regardless, the total survey pie is split pretty evenly between the bullish (positive), neutral and bearish (negative) camps. To me, these results indicate there isn’t a lot of strong conviction in any direction among individual investors right now. What will happen from here is anybody’s best guess. The rate of change from week to week among the three options will likely be most informative going forward. However, there may not be any significant movement in any one direction for a number of weeks, if not months.

 

 

My personal opinion: the market seems to want to move higher irrespective of the abundance of pessimism out there. I can’t say if any move higher will be sustainable but barring any meaningful unexpected negative catalysts the short-term trend appears to be pointing up, not down.