A New Market Sentiment Indicator

April 11, 2014

 

To better facilitate comparison to AMSI, we computed 1 minus the percentile values of VIX and the put-call ratio. Low levels of each indicator signify anxiety or fear, while high levels signify complacency or greed.

For the sake of comparison, all sentiment indicators are converted to percentile levels. VIX, designated in red, meandered around its long-term average of 20 (corresponding to its middle percentile levels) from the beginning of 2007 through the middle of 2008, providing little indication of the complacency or risk that had made its way into the market. VIX surged only after the credit crisis moved into full swing in the latter portion of 2008 and remained above its average of roughly 20 (or median percentile) throughout much of 2009. The put-call ratio provided generally high readings throughout the credit crisis. This ratio is often a contrarian indicator, with high levels of the indicator usually considered to be a bullish signal. AMSI, however, provided indications of complacency in the first half of 2007 and then consistently remained at anxiety and fear levels until the second half of 2009, when the credit crisis began to slowly fade into a bad memory for investors.

In our view, AMSI’s use of multiple factors provides it with a more robust indication of market sentiment and, therefore, may give fewer false signals and is capable of adding more value than either VIX or the put-call ratio. During this challenging period, AMSI demonstrated more cyclical behavior than either of the more established indices, consistent with the thoughts of Dow and Graham. The put-call did not provide any indication of the enormous risks that lied ahead. Conversely, VIX stayed in the fear zone throughout much of the credit crisis and its recovery, thereby failing to capture the shift in sentiment that had occurred.

Summary
In summary, we believe the benefits offered by AMSI are substantial. First, in our view, tracking7 AMSI on a regular basis will provide a more robust measure of market sentiment than the VIX, the put-call ratio or other indicators. As such, it should help investors gain a better perspective on and insight into the current relationship between the levels of risk and potential return in the market. Second, given that better perspective, it can be of help to professional investors, including those advising institutional and ultra high net worth clients, by providing a framework for a more meaningful dialogue about the nature of risk and return with their constituents. Third, during periods of extreme readings, it may offer some insight into the probable direction of the S&P 500 over the six- to 12-month period ahead. Lastly, because the temptation to abandon well-thought-out long-term plans is usually highest at market and sentiment extremes, tracking AMSI also becomes an important guardrail with respect to adherence to investment policy statements and maintaining proper portfolio risk management controls.

References And Endnotes

  1. Dow, Charles, 1901, “Watching the Tide,” The Wall Street Journal, Jan. 31, p. 1.
  2. Graham, Benjamin. 1949, “The Intelligent Investor,” 1st edition, New York: Harper & Brothers.
  3. J.P. Morgan, Guide to the Markets: 2Q:2013, April 1, 2013, p. 63.
  4. www.Reference.com (for definition of complacency)
  5. Nicholson, Francis, 1960, “Price-Earnings Ratios,” Financial Analysts Journal, 16(4): 43-45.
  6. Marks, Howard, 2013, “Howard Marks: We’re Not at Bubble-Type Highs,” Barron’s, Nov. 27. Accessed at http://online.barrons.com/article/SB50001424053111904642604579223961257360926.html#text.print
  7. AMSI and its component values, along with commentary on the index, are published each month at www.acertuscap.com.
 

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