Winnie the Pooh and the Market

“Pooh always liked a little something at eleven o’clock in the morning, and he was very glad to see Rabbit getting out the plates and mugs; and when Rabbit said, ‘Honey or condensed milk with your bread?’ he was so excited that he said, ‘Both,’ and then, so as not to seem greedy, he added, ‘But don’t bother about the bread, please.” — A. Milne (1882-1956)

Sentiment, as some of you might know, is something of a contrarian indicator—particularly when viewing the sentiment (opinion) of the retail investing public. Too many happy retail investors leads to too much ownership of risk assets which often leads to a market top. The data behind this theory tends to show reasonable predictability in determining market tops and bottoms on reliable sentiment indicators like the Put/Call ratio, the Smart/Dumb money confidence ratio, VIX, and public opinion/media bias. Essentially, sentiment tends to measure greed and fear. As Winnie the Pooh illustrates in the above quote from Milne’s storybooks – nobody likes to admit they are greedy. Investors like to think they are perusing prudent investment strategies when they pile into or out of equities in mass – but their actions speak louder than their words.

There are a few gages I tend to look at when assessing market sentiment. One of them is the CRB index that sentimentrader puts together. Really, it’s just a compilation of public opinion surveys done by such renowned sources as Ned Davis Research, Market Vane, Bloomberg, Larry Williams and others. When this indicator reaches extremes, it’s been a highly accurate indication of major market tops and bottoms. It’s a big, macro indicator – and it tends to move slowly. And right now, it’s not indicating an overdone market in either direction. So from a macro perspective, the CRB is suggesting no major top or bottom is in place right now. The chart below, courtesy of sentimentrader, shows us that the compilation line of the CRB is midway between extremes. This bodes well for mid termed investors in the market.

A shorter termed indicator created by sentimentrader that I also follow is the Risk Appetite Index.

This indicator is a compilation of various research analysts (Citigroup Macro Risk Index, Westpac Risk Aversion Index and UBS G10 Carry Risk Index Plus).  They look at market behavior indicators like credit spreads, equity and foreign exchange volatility, gold prices and sector relative performance (such as between defensive sectors like utilities and economically sensitive sectors like financials).

To quote their website: “As the index rises, it means that investors are becoming more and more risk-seeking. An index reading of 1.0 would mean that they are the most risk-seeking possible. As the index falls, investors are becoming more and more risk-averse. An index reading of 0 would mean that everyone has gone into a bunker and stored canned goods for the next apocalypse.” As you will note on the chart above, Pooh is indeed becoming very greedy and risk-orientated. As a shorter termed indicator than the CRB, that might be something of concern to short-mid termed investors.

The VIX is often used as a neartermed indicator for market risk appetite. Below, you can see a puzzling tendency recently for the VIX to remain below my pre-drawn “danger” zone of complacency. Typically, the VIX doesn’t stay this low for such an extended period while markets rise. History does tend to repeat itself eventually, and the low VIX level should be of concern to neartermed investors.

The Put/Call ratio measures the net trading activity in defensive (puts) options vs. bullish (call) options. Too many puts (compared to trading in calls) means too much pessimism – and vice versa. But only at extremes. I’ve drawn a line at the ratio of 1.25 puts/1 call as bearish (top line) and 0.75 puts/1 call as bullish (bottom line). Currently, the ratio stands at around 0.9 puts /1 call. This is a neutral rating.

Finally, I will also note that my favorite sentiment indicator, the Smart/Dumb money ratio of confidence, remains in bearish territory with a high level of confidence by retail “dumb” money – contrasting a low level of confidence by the more investment savvy “smart” money group. Note the low level of confidence by “smart” money (blue line) vs the high confidence by “dumb” money (red line). Do a search on this blog for greater explanation of who’s opinion it is that sentimentrader tracks to formulate these two groups. This too can be a shorter termed market indicator, and as such, suggests some potential for neartermed correction.

Conclusion

While some of the indicators suggest caution, some of them suggest no need for worry (specifically the Put/Call ratio, and the CRB public opinion compilation). My two cents worth:  there is probably some room for a correction in the near-term, but the balance between these indicators suggests a correction, if any, may not be too extreme.