Long-term Sentiment: 2001 to Date

Anyone who studies U.S. equity markets from 2001 to date can learn a lot about market sentiment.  Our prior posts in this series showed valuation in terms of the so-called "Fed Model" and the immediate impact of the 2001 recession.  Readers should check the links to these former posts as background.

Following the discussion is helped by reference to the timeline of valuation (the red line) and various events and emotional factors.

9/11

I have been anticipating some economic studies of the real economic impact of 9/11.  The terrorist attacks came at a time of apparent economic fragility, leading to several significant effects:

• Certain market sectors, notably airlines and travel destinations had big hits.
• Consumers seemed to "hunker down" and stay home.
• Businesses became cautious about investment.
• IPO's disappeared.
• Venture capital dried up.  This has been little discussed.  As someone who works with early-stage companies, this was a death knell for many depending upon private investment for growth.  Venture funds had to keep pumping money into current businesses, given the lack of IPO chances.
• Market participants, reacting to anthrax and other scares, wondered when and where the next attack would come.

The overall effect was to stifle the normal progress of business investment.  This is yet another reason that economists and market analysts should not have expect a "normal" recovery from the recession.  It seems obvious, but it draws little comment, as market researchers continue to compare the recovery to those of the past.

Longshoremen Lockout

At the worst possible time, in Autumn of 2002, a possible strike by Longshoremen disrupted the economy.  Estimates put this effect at about $20 billion, even though President Bush invoked the Taft-Hartley Act after ten days.  When things are fragile, every effect is important.

Prelude to War

At about the same time, the U.S. was preparing to attack Iraq.  The effort to gain public support continued for months.  Businesses had a natural reaction.  Anyone watching CEO interviews on CNBC or listening to conference calls could see this time and again.  Businesses delayed new investment and new plant construction.  It was a time of uncertainty, and business responded cautiously.

This attitude readily carried over into hiring.  Faced with rising benefit costs, businesses chose to retain consultants and temporary workers, preserving flexibility.  This depressed the normal increase in payroll jobs.  At the same time, consultants interviewed in the household survey responded that they were employed.  People were working and earning a living, but it did not show up in the payroll employment survey.

Scandals, Housing, and the Individual Investor

A series of scandals were exposed, publicized and prosecuted.  Some companies had clearly committed frauds related to earnings, and the stain affected those who had been honest.  Some brokerage analysts had inflated expectations and stock ratings.  Highly visible public prosecutions and settlements led the average investor to conclude that "the game was fixed."  Any of us working with individual investors during this time could see the impact.  The flow of funds data on mutual funds confirmed this.

This has a continuing multi-year impact, as the key cases continue to command news attention.

At the same time, interest rates fell low enough to make mortgage payments more affordable.  While everyone talks glibly about a "housing bubble" there was also some reality to this shift.  Individual investors chose to refinance mortgages at low rates, paying them off more quickly.  They bought vacation property.  They moved to larger homes.

Real estate seemed more attractive to the average investor for several reasons:

1. They knew that property could not go to zero the way some of their stocks had done.
2. They heard many stories of success -- big success -- and chased the performance.
3. New financing alternatives made it easier to invest money -- even IRA money -- in real estate.

Real estate became a new asset class to compete with stocks and bonds, largely because of perceived value and liquidity.  Whether or not these perceptions were accurate is not the point.  The effect was to draw the average investor out of stocks and into a larger real estate commitment.

Fear of Deflation

The economic environment included a well-founded fear of global deflation.  The Fed responded by reducing interest rates to levels not seen for many decades.  While today's smart aleck commentators now view this as a Fed error, no one knows what would  have happened had they not acted as they did.  The Fed team realizes that deflation is harder to fight than inflation, and they took their best shot.  It is quite likely that the Fed action in cutting rates was a major contributor to getting the economy back on track.

Rising Oil Prices

The economy suffered another blow from rising oil prices.  This was a combination of rebounding global economies, weather factors, and speculation.  While economists counseled that the oil price increase was less significant and important than it was in the 70's, many market strategists paid little heed.  Many bearish commentators called this a return of stagflation and predicted economic disaster.  This was more than enough to keep individual investors on the sidelines.  While the actual economic performance has proved these analysts wrong, the market impact was quite real.

The 2004 Election

All is fair in electioneering, and the economic debate made this clear.  While the Democrats did not win the White House, they contributed to a widespread perception that the economy was weak.  Polls showed that people believed there was a recession.  Newspaper articles trumpeted a "jobless recovery" even while unemployment rates remained low.

Please note that this is a market comment, not a political one.  Candidates use symbols and fear to make the best possible case.  The impact on investors was to scare them out of a nice rally in stocks.

The Fed Rate Hikes

As soon as the Fed started raising rates from the incredibly low levels used to fight deflation, market pundits invoked the old slogans.  Don't fight the Fed.  Three steps and a stumble.  Leading commentators acted like a move from negative real interest rates to the Fed's neutral zone as if it were a serious brake on the economy.  The widely publicized series of 25bp increases was a further chilling effect for investors.  For most of the period, the Fed was still stimulating the economy, albeit at a lesser rate.  This obvious fact was lost on many Street analysts and nearly all individual investors.

It is only the last few hikes that have moved rates beyond the Fed's definition of "neutral."  Some would argue that current levels are still close to neutral.  Briefly put, the Fed has been withdrawing stimulus throughout this time, not putting a serious brake on the economy.  In fact, rising oil prices and other factors, like hurricanes, have done much of the Fed's work.

The Result

Individual investors were scared out of the market in 2001.  Most of them have not returned.  Mutual funds geared to domestic equities have dwindled while hedge funds and emerging market ETF's have gained assets.  Even domestic managers held higher than normal cash levels and sneaked in foreign ADR's during this period.

It has been an unprecedented period of negative sentiment, chasing many investors out of stocks.  While the short-term sentiment measures reflect the attitudes of those trading every day -- AAII, put/call ratios, newsletter writers, blogger polls, and the like -- the facts show that overall sentiment remains quite negative.

In the next entries for this series we will examine how this perspective helps in interpreting the current market environment.  We will also look at criticisms of the Fed Model.  Finally, we will consider what it all suggests for investment opportunities - what stocks?  what sectors? -- are best for 2007.

Comments

[oldprof]

Hi Mike,

Thanks for your helpful comments. As my readers know, I am working on a book on these topics. Any comments and criticisms help me to sharpen the analysis and also spot errors. I know that many are reading without commenting, and I really do wish that more would offer their viewpoints.

To your points --

On the M3 issue, my current impression (pending some more work) is that this is a tempest in a teapot. The Federal government cannot effectively conduct conspiracies, so I tend to take the Fed's explanation for dropping the series at face value. They provided a technical explanation for why M3 was no longer helpful, and I'll try to do more research on this for a future topic. At the moment, I do not think it is relevant to overall market valuation.

As to traditional sentiment indicators, we also trade very short-term models and track these for that purpose. My point here is that people have different time frames. Those with a longer horizon can usefully view the valuation gap as reflective of sentiment. Short-term sentiment can still help in the timing of entry points.

On mutual funds, we have a lot of data covering the entire time period. This was not suitable for this overview post, but will be the subject for more detailed analysis and the book. For much of the time period, mutual fund managers have been dealing with outflows and have needed cash for redemptions. I hope that you will keep reading and let us cover this in more detail in the future.

Thanks again for your helpful comment!

[mike turner]

Dr. Miller,

I take issue with some of your statements.

1. 'Briefly put, the Fed has been withdrawing stimulus throughout this time'

How do you know? since M3 reporting has vanished. Up until it disappeared, money was being printed at double digit increases.

2. "While the short-term sentiment measures reflect the attitudes of those trading every day -- AAII, put/call ratios, newsletter writers, blogger polls, and the like -- the facts show that overall sentiment remains quite negative.

Are you sure? My research shows that most short term traders don't have a trading opinion. They trade and trail a stop either direction depending upon their strategy and indicators. My research also shows COT reports covering the major indicies as short or neutral at best.

3. Even domestic managers held higher than normal cash levels.

My research finds that most mutual funds are fully invested with less than 5% cash reserves.

IMHO