Four signs that the rally won't last
By
Deputy Editor
Tim Bennett May 15, 2009
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Stock markets have seen a massive rally since the start of March – the S&P 500 has leapt by around 28% in just 33 trading days to record its sharpest rise since the 1930s. But watch out. Four sentiment indicators suggest the surge may be set to stall.
1. Newspapers are less gloomy...
The Dow Jones Economic Sentiment Indicator (ESI) summarises the economic coverage of 15 major daily US newspapers, combining the data into one number between 0 and 100. A high number suggests most newspapers are bullish – which, as contrarian investors will know, can be a good sign that the market is about to turn down. And indeed, since 1990 the ESI "has proved reliable in identifying nearly every major economic downturn and recovery", says Money Talks columnist Alen Mattich in The Wall Street Journal.
In November the index hit 22.2, "the lowest monthly result in nearly two decades of testing" – a clear buy signal. That was a little early – the best time to pile in would have been March – but still not a terrible time to buy. But the papers have been getting steadily less miserable since then – the reading for April was 27.6. That's 25% above November's reading, and suggests that the time for anyone hoping to trade a short-term bounce is past.
2. ... And so are investment advisers
The American Association of Individual Investors (AAII) has been producing adviser sentiment surveys for about 20 years. The historical average reading for the AAII survey has 38.9% of advisers bullish, 31.2% neutral and 29.9% bearish. As Seekingalpha.com notes, in March the bearish reading hit a record 54.47%, again a good buy signal. But for April, the bears fell to 43.61%. Meanwhile, an Investors Intelligence newsletter survey has bulls outstripping bears by 40.4% to 31.5% – "the lowest level for the bears since June 2008". Again, this suggests that, as more bears turn bullish, the rally will lose steam.
3. Insiders are bailing out
A more concrete indicator is also flashing. Company directors "should know more than outsiders so you can take it as a signal there's something wrong if they are selling", says William Stone, chief investment strategist at PNC Group. And the signs aren't good. In April, US directors dumped $353m-worth of shares – 8.3 times more than they bought, says Michael Tang on Bloomberg. Moreover, the $42.5m spent on buying shares in April was the smallest monthly amount invested since July 1992. So it seems that insiders don't trust the current rally either.
4. The 'fear gauge' is flashing red
The Chicago Board Options Exchange's Vix index captures the volatility (high volatility means more fear) expected by S&P 500 options traders. The rule is simple: buy when it's high. But how high? The Vix is currently sitting at around 33, well above the 20.09 average over its 19-year history, albeit well below the all-time peak of 81 hit just after Lehman Brothers collapsed. But a survey of 75 money managers and traders carried out by Macro Risk Advisors shows that they expect the Vix to jump to 52 by the year-end. That's a fourth sell signal.
So what should investors do?
Because of the fragile financial sector and the grim economic environment, in recent months we've encouraged readers to pick and choose stocks carefully rather than just pile into the market. And with four big sentiment indicators suggesting that the rally may be getting long in the tooth, we'd continue being selective in our stock picking right now.
Five keys to investment success
Richard Bernstein, Merrill Lynch's chief investment strategist, retired last month after 20 years at the bank. In his final note he lists his ten keys to investing success. Here are five that we think are particularly useful to remember.
1. Income matters as much as capital gains. Standard & Poor's estimates that 40% of the total return from the S&P 500 index over the last 80 years came from dividends.
2. Diversification doesn't depend on the number of asset classes in a portfolio. In a crisis, many asset classes collapse together. Better to find just a few that are uncorrelated.
3. Return on capital is typically highest where capital is scarce. The best investments are often unfashionable. The less competition your money faces, the better.
4. Investors should research financial history as much as possible. To judge where a stock or asset class might be heading, you first need to grasp how it got here.
5. Leverage gives the illusion of wealth. Saving is wealth. Debt finance can magnify paper returns. But hard cash is what counts. So always check the balance sheet!
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