How to avoid the madness of crowds
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Deputy Editor
Tim Bennett Sep 11, 2009
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"At turning points, the correct view is, by definition, the minority view," says Anthony Bolton, Britain's answer to Warren Buffett, in the Financial Times. That's why he likes sentiment indicators. "If these indicate that investors have voted one way, it normally always pays to bet against them."
Why sentiment matters
There are basically three methods you can use to decide which way share prices will go next. The first is fundamental analysis – using ratios to decide whether shares are cheap or expensive. That's fine, but right now opinion is divided. If we are emerging from a short, sharp V-shaped recession, then some would say that shares are still cheap. The FTSE is still more than 10% below the 2008 peak and, at 12.5 times future earnings, valued below an average price/earnings ratio of 15. But if we are about to hit the second dip in a recessionary 'W' (as economist Nouriel Roubini has claimed) the bull run will be stopped in its tracks.
Method two is charting – using past share-price patterns to predict the future. "History repeatedly shows that rallies rarely make extended one-way moves," says David Schwartz in the FT. Given that "big gains in the run-up to September are typically associated with September price drop", a "healthy correction" should be on the cards. Trouble is, "there are always exceptions to the rule" and predicting when a dip may come is tricky. For example, Morgan Stanley data show that, during the last 19 recessions, stocks fell by more than 20% after rebound rallies. But these rallies lasted an average of 17 months each and lifted stocks by around 70% at a time. So far the rise since March has been a more modest 40%, so there could be more upside to come before the next dip.
Another problem for chartists is central banks. A global monetary stimulus (rock-bottom interest rates and money printing) of this size has never been tried before, which may be why established techniques for predicting share prices have proved pretty hopeless in the past six months.
Hence, as Bolton notes, the importance of sentiment indicators; in the short-term at least, the best bet may be to set aside p/e ratios and charts and focus on what investors think will happen next. With the FTSE 100 up about 40% since its March low, what do these indicators say now?
The ESI points south
The Dow Jones Economic Sentiment Indicator (ESI) aims to predict the health of the US economy by looking at the coverage of 15 major daily newspapers. The balance of sentiment between bulls and bears is given a number between 0 and 100. Last November the index hit 22.2. That lack of confidence was a clear buy signal for a contrarian investor. But the papers have grown steadily more bullish since then. In August, the ESI hit 35.5, having risen for six months in a row. Although sentiment can't be said to be outright bullish until the indicator hits 50 or above, the speed of the recent rise points to a pull-back for shares.
Insiders are nervous – outsiders are bold
"The huge gap between buying and selling volume by corporate insiders is eye-popping," notes Schwartz. According to research by TrimTabs, the current ratio of insider selling to buying is now 30:1. This suggests "an absence of hope" among company directors about their firms' prospects. That's hardly positive for share prices.
Meanwhile, private investors are worryingly cheerful. Although we all know we should buy low and sell high, too many small investors do the opposite – rushing in as the market peaks and selling just as it bottoms out. For example, at the world's biggest stock exchange by volume, in South Korea, bullish private investors have been placing some monster-sized bets.
According to the Korean Times, outstanding loans to private investors from securities firms hit 4.54trn won by 3 September – in other words, private investors are borrowing that much money to bet on stocks. That's a 201% rise since the start of the year and the highest level recorded in 2009. Analyst Kim Dong-ha warns that the current level of such loans – taken out as investors seek to claw back previous losses on shares by betting big as the market rises – is "excessive" and could soon trigger "huge losses".
Fear is rising
The Chicago Board Option Exchange (CBOE) Vix index – which reflects the amount investors are willing to pay to protect themselves against falls in stock prices – "tends to move up when stocks move down and vice versa", says Tennille Tracy in The Wall Street Journal. Just last Tuesday the index hopped up 12% to 29.2, its highest level since 9 July. That's some way off its recent peak of 81, seen just after Lehman Brothers collapsed. But given that "investors expect the Vix to pop higher in coming weeks", you should be cautious. For example, says Matt Shapiro, a market maker with Stutland Equities, futures contracts on the Vix for October are trading at around 32.
So what should you do?
"Investors who missed the huge rally of the last six months will now probably strive to catch the next leg up," says Schwartz. That, plus a flurry of mergers and acquisitions activity, could keep shares moving up a little longer. But with recent corporate profits growth underpinned by cost-cutting and one-off stunts such as the US 'cash for clunkers' programme (to boost sales of new cars), or the temporary cut in UK VAT, the many indicators pointing to a drop in share prices are likely to win the day soon.
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