The investment community is quite comfortable these days, at least in a statistical sense. In this article I examine measures of investor complacency and what they may signal for the stock market.
The first statistical indicator examined is the Investors Intelligence advisor survey. This organization surveys over 100 independent newsletter authors/advisors and determines their current market stance. This survey has been in existence for over 50 years and over that time only four analysts have made the qualitative assessment of newsletter posture. When the survey was originally developed, it was hypothesized that when advisors were bullish, it was most advantageous to ride with the bulls. Investors Intelligence discovered quite the opposite – strong bullish sentiment was most evident near market tops. Conversely, strong bearish sentiment was typical near market bottoms. Even with this measure it is important to quantify what is “strong” sentiment. Investors Intelligence established a “normal” reading of 45% bulls, 35% bears, and 20% neutral. While this demonstrates a plurality of bulls, it is considered a typical reading. I am actually surprised their normal state does not reflect a higher percentage of bulls. Investors Intelligence focuses their attention on extreme readings and their duration. They believe that when too many advisors think the same thing, they are wrong. This is consistent with comments made in E$caping Oz Chapter 9 on investor psychology. Once everyone is on board with a trend, there are no new entrants to drive the trend.
At the beginning of June, the advisor survey noted over 62% bulls – this counts as an extreme reading. How extreme you ask? Consider that since 1987 there have been only 3 readings above 62%. The other two occasions were in 2005 (preceding the real estate top) and in 2007 (preceding the historic stock market top). During the month of May I saw several statements in financial news sites about “selling in May and go away.” Ironically, the discussion about this cyclical pattern did nothing to fan the bullish flames in the stock market. On a parenthetical note, I see more and more discussion about how high the market is and at least some in the media questioning it. This questioning had bullish advisors expecting a correction as a normal component of this market run. When the correction did not come in May, more advisors came over to the bullish side in the Investors Intelligence survey. This is quite the struggle between the rational prefrontal cortex and the brain’s emotional limbic system. Even when bullish expectations were logically tempered for some advisors, the market spoke otherwise. Thus, the advisors rode the bull despite the market’s non-retreat.
The Federal Reserve Bank of St. Louis maintains a very interesting financial stress index eponymously named the St. Louis Fed Financial Stress Index (STLFSI). This index, begun in 1993, comprises 18 separate measures heavily focused on interest rates and interest rate spreads. The STLFSI also contains two specific stock measures, the VIX and the S&P 500 Financials index. The STLFSI suggests that changes in the levels of stress in the economy will make the various components move in sympathy. The index oscillates around the value of zero (0) representing normal financial market conditions. Values below zero imply low stress while those above zero imply high stress. For the week ending June 13, 2014, the index measured (-1.303), which was even lower than the previous week’s value of (-1.264). Let’s place these values in some context. For the week ending May 30th, the STLFSI fell to its lowest level on record at that time (-1.281). The previous record low was in February of 2007, a few months before the stock market top. So just in the last two weeks, we have two new all-time lows. The graph in the first slide, highlighting the last two years, shows financial stress that never reaches the zero value. Notice the persistent downtrend for the last year.
For the purposes of comparison, let’s see what the index looked like during the tumultuous 2007-2008 period (second slide). The index began to turn up a couple of months before the stock market top of October 2007. After descending back to the zero level on October 12th, 2007 the index started its near parabolic climb during the next year towards a crescendo in October of 2008. Of course from October 2007 to October 2008 the Dow Jones fell by over 6,000 points. I show this graph to illustrate what happens to the STLFSI when markets get real stressed. The top level in the STLFSI came a mere 5 months before the major stock bottom of March 2009.
Historically, low levels of stress preceded stock market tops (1998, 2000) and higher levels preceded stock bottoms (2002, 2009). The level of the index is significant in identifying the position of the market (are you closer to a high or low). The index, however, does not provide the timing.
The next and last measure of investor complacency is the VIX or Volatility Index. This index is thought of as a fear gauge and it specifically measures the variance of at-the-money options on the S&P 500 index. The lower the value of the index, the greater the degree of investor complacency. The numerical value derived for the index suggests the expected move in the next 30 days. As I write this on June 20th, the VIX is about 11. A VIX of this level suggests investors anticipate a move of (11/√12 = 3.1) 3.1% either up or down. The VIX level of 11 is historically low volatility. Let’s put the volatility in a more recent, historical context. If we examine the 2007-2008 period once again, we can see what happens when the markets get nervous.
The next chart (third slide), courtesy of Yahoo Finance (top) and Commodity Systems Inc. (bottom) shows the VIX (top) and Dow Jones Industrials (bottom) for the 2007-2008 period. The first downward arrow points at July 2007 where the Dow made a top near the same level as the important October 2007 high. The VIX increased noticeably after July 2007. The other important point on the VIX chart is in November of 2008. This very elevated level of the volatility index, matched the month prior, occurred 4 months before the major stock low of March 2009. Low VIX readings tend to precede stock highs and high readings can precede stock lows. This is not to suggest that just because the VIX is at a particular level, it implies a stock high or low. Use the VIX reading in conjunction with stock market levels and other measures to understand how complacent a market may be. If you utilize this approach, we are at historic complacency after a strong five year bullish run.
Every complacency measure I cite in this article is reflected in the behavior of retirement plan participants. According to Aon Hewitt, which tracks 401(k) investments at large corporations, plan participants are directing 67% of their new contributions towards stocks. This is the highest level since March 2008, 5 months after the stock market top of October 2007. Even at the bottom in March 2009, investors still poured 56% of their investments into stocks. The bull run since 2009 has resulted in stocks comprising 66% of 401(k) assets.
There seems to be more of an appetite for risk taking. As I have noted in other articles, this risk taking is a product of an ultra-low interest rate environment leaving investors scurrying for stocks. As one financial planner concluded,
What am I going to do buy bonds? Equities are doing fine. But if interest rates rise, bonds could be hurt badly.
Another financial planner indicated,
It's an emotional reaction. [The years] 2008 and 2009 were like being in the fetal position. Now everyone wants to buy.
So there you have it. Investment newsletters are historically bullish. The Fed says we are experiencing historically low levels of financial stress, not normal stress but historically low stress. Investors are showing historic complacency as demonstrated by the VIX. The pain of 2008 has vanished with more retirement money directed to stocks. By all appearances, those participating in the market appear as risk-tolerant as ever. This tolerance is impressive. A professor of retirement income probably said it best,
People say that they're risk-tolerant as long as they're making money, but once they're losing money, they discover they weren't so risk-tolerant after all and sell stocks."
Rest assured, the next sell-off will be stronger. The memory of the previous stock market fall will come front and center. Sellers will outnumber buyers.
Jim Mosquera is a Principal at Sentinel Consulting, a business restructuring and economic consulting firm.