How Do We Know Where We Are in the Sentiment Cycle?

While economic and political fundamentals are difficult to assess and forecast, even doing so with precision isn’t enough to project markets’ direction. How those factors relate to sentiment—what markets have priced in—is key. So it is crucial to have a sense of where sentiment is. Which is really hard! But it is doable, especially if you know where to look. Here are some things we think investors should—and shouldn’t!—look at to help gauge where markets are in the sentiment cycle.

The following are just a smattering of sentiment gauges we follow. While none (or a handful) in isolation tell you much, tracking several provides a good starting place. Among our go-to reports are The Conference Board’s Consumer Confidence Index, the American Association of Individual Investors’ surveys, retail fund flows, initial public offerings (IPOs), margin debt, mergers and acquisition (M&A) activity and, to an extent, valuations like P/E ratios.

Yet for most of these, headline numbers aren’t much use. People regularly say one thing and do another, and most people don’t even realize they are euphoric when they are, never mind tell a stranger over the telephone their present mood resembles how one might feel midway through a Vegas bender. But by looking at spreads between various confidence measures or spikes in the rate of change, you can glean more useful information. For instance, neither of The Conference Board’s two headline measures—the Present Situation Index and the Expectations Index—say much on their own. Expectations tend to fluctuate in a narrow range even when people are euphoric, and sentiment toward the present tends to improve as a bull market wears on. But a wide gap between the two can be telling. Margin debt also usually rises as bull markets mature, and no set level is inherently bearish. But if it spikes in a short period, that can be a sign of euphoria. As for P/Es, the level itself isn’t telling about market direction but can, if put in proper context, hint at where sentiment is. Right now, none of these indicators are flying off the charts—they are drifting higher gradually, which is consistent with warming optimism in a maturing bull market.

You may have noticed there are some popular supposed sentiment indicators we left out. Like the VIX! People call it the “fear index,” but it merely tracks options traders’ expected volatility and doesn’t differentiate between upside volatility and downside. Similarly, CNN’s Fear & Greed Index (FGI) amounts to backward-looking technical analysis—a mashup of the VIX, credit spreads, moving averages, market breadth and some others we won’t bore you with. Consider: A year ago the FGI registered 88 on a scale of 0 to 100—extreme greed by CNN’s reckoning! The S&P 500 has risen every month since. Pundits tout the Economic Policy Uncertainty Indexsince it purports to show policy uncertainty is unusually high presently. But it merely mines keywords in the news—effectively tracking sensationalism, linguistic trends and media’s quest for eyeballs more than prevailing sentiment. Finally, while we study valuations, the Cyclically-Adjusted P/E (CAPE) ratio isn’t one of them. Comparing nominal stock prices to 10 years’ worth of inflation-adjusted corporate earnings is bad, backward-looking math. Today, earnings from the global financial crisis are in CAPE. How is that relevant to sentiment now?

Gauging expectations is more art than science, and it is impossible to quantify something that by nature is qualitative. Sentiment is just a term for society’s feelings. No numerical gauge will ever perfectly capture this. So, we look at a variety of squishier measures. Media’s tone is a biggie. Early in bull markets, you usually see what we call the “pessimism of disbelief”: All news is either bad, soon to turn bad or couched as bad. As in, “GDP might have grown this quarter, but soon it will fall because of X, Y and Z.” Or, “Factory orders rose, but here are all these signs demand is fleeting.” Any market downturn must surely be the start of something awful in the media’s eyes. Headlines laugh at anyone with the chutzpah to be bullish. But as the expansion continues, coverage slowly becomes more positive. In a typical maturing bull market, most commentary on strong economic data is matter-of-fact—not trying to find a cloud in a silver lining. This is where we believe sentiment is today. At a peak, you get the opposite of the pessimism of disbelief. All news is good news, soon to turn good or couched as good. Headlines use weird illogic in a vain attempt to rationalize optimism. Any downturn must be a brief buying opportunity en route to rip-roaring returns. Anyone with the chutzpah to be bearish gets ridiculed.

Looking at the “why” behind some of the more quantitative indicators also helps. For example, IPO and M&A figures by themselves don’t tell you much. The quality of companies and deals between them matter much more. Think back the late 1990s and early 2000 when anything with “dot-com” in the name could have a soaring IPO even if it lacked a sound business plan, never mind cash flow. That is a world away from the high-quality IPOs we have seen in recent years. Frenzied M&A deal making—especially all-share transactions—can also signify (and generate) froth. Currently, most M&As are all-cash, which reduces stock supply. In the dot-com boom, all-share deals were well over half of all M&A activity, adding to the surplus of stock supply.

While sentiment is often the opposite of reality at extremes, rote contrarianism is folly. Blindly doing the opposite of what the “crowd” expects is just too extreme. Euphoria often does imply a top is somewhere nearby. But this isn’t an exact science, and reacting to the mere appearance of stretched sentiment overlooks other factors. Sentiment is only one market driver. Economic and political fundamentals matter, too. Sentiment only tells you the degree to which markets have likely priced either in.

Taken altogether, we believe investors are rationally optimistic today. Not irrationally so. Given widespread positive fundamentals and gridlocked governments, that makes sense to us. That means there is likely further bull ahead.