A New Market Sentiment Indicator

April 11, 2014

 

The Value Of AMSI In The Investment Process

Indicators do as their name implies—they indicate. As such, they need not be predictive to add value. For example, the Dow Jones industrial average is a barometer of U.S. blue chip stock market performance that is generally not used to forecast future stock market returns. While neither AMSI nor any other indicator is a silver bullet able to forecast future stock market returns with a high degree of accuracy, as we noted earlier, a well-designed indicator of market sentiment can add significant value in the investment process.

In our view, AMSI adds value from several perspectives. Tracking AMSI on a regular basis may provide a more robust measure of market sentiment than the VIX, put-call ratio or other indicators. AMSI, along with a concurrent analysis of its component parts and moving average, should help investors gain additional perspective and insight into the current relationship of market levels of risk versus potential return. Lastly, sentiment readings can also play an important role with respect to adherence to investment policy statements or structuring portfolios with proper risk management controls. This is the case because the temptation to abandon well-thought-out long-term plans is typically highest at market and sentiment extremes.

Figure 6 provides information on the historical distribution of AMSI and forward-looking S&P 500 returns. In general, an AMSI level of 0-25 indicates fear, 25-50 indicates anxiety, 50-75 indicates complacency and 75-100 indicates greed.

Risk Parity

AMSI levels at the extremes are somewhat rare, typical of most bell curve distributions. AMSI levels of 80-100, indicative of high levels of greed (an extreme version of complacency), occurred roughly 1 percent of the time since our measurement period began in January 1986. Similarly, AMSI levels of 0-20, signifying high levels of fear (an extreme version of anxiety), were also uncommon, occurring only 6.0 percent of the time. However, market returns for the six- and 12-month periods ahead of these extreme periods are striking and aberrational. High complacency/greed levels following periods of extreme market performance portended lower-than-average returns, with six- and 12-month gains of 1.7 percent and 8.7 percent, respectively. Conversely, high anxiety/fear levels following significant market sell-offs historically indicated high future returns, delivering on average 8.3 percent and 10.2 percent for the six- and 12-month-periods ahead. A similar return pattern was observed for less extreme AMSI levels in the 20-40 range versus the 60-80 range. An analysis of median returns yielded similar results.

While the findings at the extreme levels are not statistically significant due to the small sample size, they are anecdotally very interesting. The forward returns posted after these extreme AMSI readings are telling, because they point to periods when investors may have been acting either out of anxiety, fear, complacency or greed. This is consistent with behavioral finance studies that have shown that investors tend to follow near-term trends. The value of this information is that it alerts investors to the need to seek protection during high levels of complacency or greed and remain invested or perhaps become increasingly aggressive when anxiety or fear is the reigning sentiment.

As would be expected, during the majority of the periods observed, AMSI provided a reading near the middle of the bell curve distribution. This finding is not surprising given that the markets are reasonably efficient and that sentiment is usually not at extremes. However, readings in the 20-80 range can also prove to be relevant despite less dramatic S&P 500 results on a forward-looking basis. Most notably, changes in the direction of AMSI, and its moving average, may be important because they provide information on whether the market is trending toward greed or fear. Furthermore, neutral readings (in the area of 50) may not indicate that the values of most components are near their means, but may instead be reflective of mixed internal signals, the analysis of which may provide substantial insight into market sentiment.

 

 

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