Bubble Trouble?

12/9/2013


With a touch of envy and a hint of regret, investors leaped into the stock market this year. U.S. stock mutual funds and exchange-traded funds attracted $286 billion through Oct. 31, the most since 2000, according to TrimTabs.

Positive fund flows signal that investors are recovering their appetites for risk.

A greater acceptance for risk, coupled with the resurgent stock market, has led the financial press to become preoccupied with possibility of a new bubble forming. The S&P 500 Index has gained 169% from its 2009 low and eclipsed its prerecession peak by 15%. One voice of dissent in the chatter about bubbles is legendary investor Warren Buffett, who said last month that stock valuations are "in a zone of reasonableness."

Improved profit growth could support higher stock prices. The consensus calls for 11% profit growth for the S&P 500 in 2014, and estimates have held up fairly well over the past five months.

Despite this year's rally, the 2008 meltdown is still fresh in everyone's mind, causing investor sentiment to remain skittish. And that could be a good thing. "The riskiest thing in the investment world is the belief that there's no risk," says Howard Marks, CEO of asset manager Oaktree Capital Group ($56; OAK).

Bullish sentiment for individual investors sank through much of November, before surging in the final week to 47%, according to the American Association of Individual Investors. Bearishness also rose to 29% for the month. We try to put these numbers in context in the table beloe.

SENTIMENT AS A LEADING INDICATOR?
About 47% of individual investors identify themselves as bullish, compared to 57% of newsletter editors. We looked at three-month returns for the S&P 500 Index since 1990 and found that current sentiment levels send a mostly positive message. After moments when 45% to 50% of individual investors were bullish, the index rose 68% of the time, gaining more than 5% about 30% of the time versus the 33% average. However, while editor bullishness in the 55% to 60% range also tended to precede market rises, large gains occurred only 24% of the time, below the long-run average.
Individual Investors:
47% bullish, 29% bearish
No. Of
Periods
Average
Return
(%)
% Up
% Down
% Up
More
Than 5%
% Down
More
Than 5%
Bulls 45% to 50%
157
1.9
68
32
30
11
Bears 25% to 30%
239
1.7
67
33
28
13
Bull-bear spread 15% to 20%
116
1.1
64
36
31
17
Total
1,234
1.9
67
33
33
14
Source: American Association of Individual Investors.
Newsletter editors:
57% bullish, 14% bearish
No. Of
Periods
Average
Return
(%)
% Up
% Down
% Up
More
Than 5%
% Down
More
Than 5%
Bulls 55% to 60%
135
1.9
72
28
24
8
Bears 10% to 15%
0
NA
NA
NA
NA
NA
Bull-bear spread 40% to 45%
14
(0.9)
50
50
0
7
Total
1,235
1.9
67
33
33
14
NA Not available.                                                                Source: Investors Intelligence.

In more than 1,200 weekly rolling three-month periods since the start of 1990, the S&P 500 Index has risen 67% of the time. It has risen by more than five percentage points 33% of the time and declined by more than five percentage points 14% of the time.

Since 1990, when the percentage of bullish individual investors was 45% to 50%, the S&P 500 went on to post a three-month gain 68% of the time, slightly ahead of the long-term trend of 67%. After weeks with 45% to 50% bullishness, rallies of more than 5% occurred 30% of the time while downward moves of more than 5% occurred 11% of the time. So historically, investor sentiment at current levels has tended to presage short-term gains, with sharp swings occurring less frequently than average.

Among investment-newsletter editors, about 57% are bullish, the most since April 2011. At these elevated sentiment levels, the S&P 500 Index has risen over the following three months 72% of the time, though volatility — swings of more than 5% — tends to be lower than historical norms.

Bearish editors stand at 14%, the lowest percentage since at least 1989. There is no precedent for the dearth of bearish editors, and rarely has the spread been so wide between the percentage of bullish and bearish editors.

The uptick in bullish investors and editors could feed the bubble talk. But using history as a guide, current sentiment appears somewhat frothy yet not at extreme levels. Moreover, a lot of money sits on the sidelines. This year's inflows have roughly offset the amount withdrawn from U.S. stock funds since 2007. "We've come back a long way from where we were five years ago," said Buffett.


Current Hotline

Stock Spotlight

Individual Stock Reports

ISRs make stock research easy!

Perhaps the most valuable two page reports available anywhere.

All the data you would normally have to plow through years of 10-K filings, earnings reports, and reams of market data to assemble — yours all in one concise report.

ISRs contain our proprietary Quadrix scores — find out how we rate all the stocks in the S&P 500.

Visit us at individualstockreports.com