Wednesday, December 25, 2019

Sentiment Tends To Provide Insight Into Future Market Returns

In investing no one metric tends to provide 100% certainty into the future direction of the market or individual stock or bond for that matter. Though sentiment measures do provide insight into the so-called mind of the market, or better yet the mind of the individual or institutional investor. This is one reason I report on sentiment and fund flows from time to time during the year.

Last week I provided an update to the weekly AAII Sentiment Survey showing bullish individual investor sentiment of 44.1% increased above its long run average bullishness reading of 38.0%. This sentiment reading tends to be most useful at extremes. For example, as the below chart shows, bullishness readings near or above 60% tend to be associated with weak or negative 12-month forward returns for the S&P 500 Index (maroon line.) Low levels of bullishness can be insightful as well. In mid December 2018, the bullishness reading reached a low of 20.9% and the forward 12-month return for the S&P 500 Index has equaled 20.9%.

Fund flows tend to be a useful contrarian variable too. Below are two charts with the first chart detailing cumulative ETF and mutual fund flows for 2019 and through 12/11/2019 as reported by ICI on 12/18/2019. The Investment Company Institute (ICI) reports this data with a one week lag. The second chart shows flows on a weekly basis.

In spite of domestic equity flows leaning heavily towards outflows in 2019, the U.S. equity market has been one of the strongest out of all global equity markets. The year to date total return for the S&P 500 Index is 31.1% with Mid Cap and Small Cap returns in the mid to high 20% range. Developed international market returns (MSCI EAFE Index) equal 22.2% and MSCI Emerging Markets Index has returned 18.0% so far this year.

Sentiment by itself is not the silver bullet in an analysis, but evaluating the various sentiment gauges can be useful in the evaluation of the potential direction of the market.

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