Market observers all want to measure sentiment. Here is the general point of agreement:
When everyone is in the market, there is no one left to buy.
and of course we have the opposite --
When most are on the sidelines, there is no one left to sell.
The general interpretation of sentiment is contrarian. The indicators include (but are certainly not limited to) the following:
- Individual investors measures, like the American Association of Individual Investors (AAII);
- The put/call ratio (interpreted as "public money" buying one or the other);
- Insider transactions;
- Who is featured on CNBC;
- Magazine covers;
- NYSE specialist positions; and
- Various polls, including those of supposed experts.
I am sure that I have left out a few, but you get the idea. Occasionally someone advertises a poll as seeking the opinion of "smart money" but everyone interprets it as contrarian anyway. It is a tough crowd and no poll gets respect!
Current Readings
Most of the sentiment measures are not objective, especially the interpretation of CNBC guests. The bears think that it is a parade of market cheerleaders. The bulls see a bunch of worrywarts. What is needed is something that you can actually measure. It would be especially good if the measure had some predictive value.
Looking for a fresh idea? Here are two new candidates:
- US versus Germany. Cramer thinks that the market is "too negative" and points out that the S&P has declined more than Germany, despite less exposure.
- Earnings reactions. In case you were not watching, the earnings reports were excellent, beating expectations and with generally strong guidance. ( I understand that some feel this was already anticipated by stock prices). Meanwhile, the results are very dramatic. The excellent team at Bespoke Investment Group highlights in one of their typically excellent graphs that this was the absolute worst earnings season in a decade. I am not going to copy their graph, but you should visit their site for a look.
Both of these ideas are measurable and objective indicators of negative sentiment.
The Very Best Sentiment Measure
There is one indicator that is the absolute best for identifying sentiment. It is the flash point between the bullish and bearish communities: Forward Earnings.
For those who view the sell-side analyst community as a work force, helping us to identify trends in future earnings, it is a dramatic and appealing prospect. The current yield on forward earnings is 7.85%, a rate close to that offered at the market lows of February to March of 2009. (Brian Gilmartin of Trinity Asset Management covers this for his client base and for TheStreet.com's Real Money site.)
By this measure, the market is just as cheap as it was at the time of the 2009 lows.
The bears believe that analysts are captives of sell-side firms and the companies they cover. It is a debate that can and should be resolved by data.
Some Comparisons
For those who want some data, I took up this topic many years ago, highlighting the error made by a prominent sell-side analyst. This article (which I think is one of my best) is still worth reading.
Here (from Tom Armistead at Seeking Alpha) is another approach, splitting the data set instead of using a quadratic term. The basic idea is that if there is a great fear of deflation, the PE multiple for stocks is low. If deflation is off of the table, stocks enjoy a multiple that competes with the higher bond yields.
Tom is getting at the same concept I found with a slightly different method.
Our Take
I think that the forward earnings yield is an excellent sentiment indicator. If we actually achieve anything close to the projected earnings, the market is cheap -- very cheap.
The conclusion is obvious. For the moment, the marginal market participant is very skeptical about future earnings.
Some big players disagree. Nick Thakore, manager of the $4 billion Putnam Voyager Fund has this take:
People have been so burned that they're missing the cyclical recovery and an epic earnings recover. It looks like 2011 could be an all-time earnings record for the S&P 500.
Conclusion
It is all about earnings. We know what to watch for and also how to place our bets.
