A New Market Sentiment Indicator

April 11, 2014

An effective indicator of market sentiment could help investors avoid the pitfalls associated with the investment performance displayed in Figure 1. A number of sentiment indicators already exist, such as the put-call ratio, the CBOE Volatility Index (VIX), as well as various surveys that attempt to take the “investment pulse” of individual and institutional investors. Each of these indicators has its shortcomings, most often caused by the omission of one or more important factors that may influence market sentiment. The challenge in designing an effective indicator is to make it relatively simple and understandable, yet robust enough to reasonably explain the levels of and changes in market sentiment. A model that is too simple will provide insufficient information, while a model that is too complex may be difficult to understand and is therefore not useful.

Our approach in selecting a mix of fundamental, technical, short-term and long-term elements for the AMSI was to include variables that make intuitive, logical and empirical sense without becoming unwieldy. The result is an indicator that uses the following five factors:

• Price/earnings (P/E) ratio
• Price momentum
• Realized volatility
• High-yield bond returns
• Treasury eurodollar (TED) spread

As described below, all these factors provide some measure of market sentiment, but each adds a unique element to the overall index.

Elements Of AMSI

S&P 500 Price to Earnings (P/E) Ratio

Since stocks represent ownership in a business, it is clear that valuations are what will ultimately matter in the long run. In the short to intermediate term, however, market psychology and other factors may cause prices to deviate substantially from their fundamental values. Hence, we believe that P/E is one of the important elements for a reasonable assessment of market sentiment.

P/E ratios have a long history of being followed by the analyst community, and for many decades they have been published in the stock tables of leading daily newspapers. The AMSI focuses on trailing P/E, rather than forward P/E, due to the former’s longer time history and the latter’s reliance on ever-changing and usually overly optimistic analyst estimates. In 1960, Francis Nicholson5 was the first among many researchers to find that low-trailing P/E levels are generally a predictor of higher stock market returns ahead, while high P/Es usually correspond to lower levels of future returns—findings consistent with the investment maxim, “Buy low and sell high.” Similarly, for the AMSI, low levels of P/E may be indicative of anxiety or fear, while high P/E levels may signal complacency or greed.

Price Momentum
Sometimes prices move in advance of the fundamentals. The movement may be due to shifting market psychology, unanticipated events or other factors. For example, investors often legally act on information before it has passed the checks and balances of the published news cycle. Some investors uncover news through original research and make it available to reporters before the news is officially disseminated. Other times, investors may trade in anticipation of a rumored policy change such as a Fed action or an event such as a military attack that may or may not come to pass. This dynamic behavior often explains the “buy on the rumor, sell on the news” pattern observed in security price movements. At other times, momentum can be driven simply by investors not wanting to be left behind the crowd. For the AMSI, high levels of price momentum are indicative of complacency or greed, while low levels may be indicative of fear or anxiety. We define price momentum as the percentage of S&P 500 Index stocks trading above their 200-day moving averages.

 

 

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