MARKET SNAPSHOT: Why Investors Shouldn't Rely On Sentiment Indicators For Market-timing

By Anora M. Gaudiano, MarketWatch Features Dow Jones Newswires

'Sentiment is a tricky thing', says Bespoke's macrostrategist Pearkes

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Several measures of Wall Street sentiment peaked this year and rolled over without a corresponding pullback in the stock market, underlining the faultiness of metrics used for timing the market that have so far consistently betrayed Wall Street investors.

The S&P 500 , which closed at 2.582.28 on Friday recorded its first weekly loss in nine weeks. Despite recent modest selling, the benchmark index is still less than half a percentage point below its peak set Wednesday (http://www.marketwatch.com/story/dow-set-to-cool-its-heels-after-another-record-close-2017-11-08).

As of Nov. 10, the S&P 500 has gone without a 3% pullback for 12 months and the 12-month rolling average implied volatility, as measured by the CBOE Volatility index has been at record lows, closing at 11.29 on Friday, nearly half its historic average at around 20.

In fact, over the past 12 months, the largest decline on the S&P 500 from peak to trough was 2.8%.

Yet, this shouldn't imply that the stock market will rise indefinitely to records, with the halting of weekly streaks (http://www.marketwatch.com/story/dow-futures-slump-70-points-as-tax-delay-concerns-spook-investors-2017-11-10) for the main U.S. benchmarks perhaps signaling that some retrenchment may be at hand.

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A gradual shift in investor sentiment, however, suggests that despite all-time highs on the S&P 500, investor sentiment is moderating. Sentiment readings are used as a sign of the mood on Wall Street, with swings at either extremes, bearish or bullish, sometimes interpreted as a contraindicator and as a buy or sell signal.

To be sure, those extreme sentiment readings don't always correspond with moves in the market.

Case in point, last month, CNN's "Fear and Greed" indicator, one measure of risk appetite on Wall Street, flashed extreme greed, prompting many strategists to call for caution in buying. However, since then, the indicator has retreated to "neutral" levels, while the market mostly clambered to new heights.

Read: Retail investors see this as the 'best time ever' to jump into stocks. Time to worry? (http://www.marketwatch.com/story/retail-investors-see-this-as-the-best-time-ever-to-jump-into-stocks-time-to-worry-2017-10-18)

Similarly, an indicator run by Nobel laureate and Yale professor of economics Robert Shiller, peaked in March of 2017 at above 90%, marking the highest level for the gauge since 1999. Shiller's "Investor Confidence" gauge has been around since late 1980 and measures the percentage of investors, both retail and institutional, who think equities will rise over the next 12 months.

George Pearkes, macro strategist at Bespoke Investment Group, publishes a proprietary sentiment index in which he combines Shiller's confidence and valuation index to gauge "irrational exuberance," a term coined by former Federal Reserve Chairman Alan Greenspan in the 1996 in reference to the dot-com bubble, which ultimately imploded in the early 2000s.

And as seen in a chart below, investors were seemingly irrationally exuberant in March of this year when they believed valuations were stretched but also believed markets would rise over the next year.

Stock indexes putting in fresh records, albeit with subdued moves higher, highlight the market's ability to defy timing indicators that suggests that a market top has been put in.

"Sentiment is a tricky thing. People respond to different market conditions in a different way. And currently, politics is a big factor in how investors feel about the market," said Pearkes.

Hopes of fiscal stimulus, with an emphasis on individual and corporate tax cuts, have helped to jolt markets into double-digit gains since President Donald Trump was elected last November. The S&P 500 index is up about 21% since Election Day and is up more than 15% so far this year.

Any news that the tax plan will be delayed or derailed has sparked selling of stocks.

"People can be optimistic or pessimistic for the wrong reasons. It would be a mistake to rely on sentiment for an investment strategy," Pearkes said. He said this doesn't mean markets can't see a small pullback in the short term, citing equity valuations considered lofty.

"With a 20% annual gain, stretched valuations and overbought conditions, markets often consolidate. I would not be surprised to see a mild 3% pullback and then record highs by the end of the year," Pearkes said.

"Often sentiment turns into a self-fulfilling prophecy," he said "For example, wealthier investors tend to be optimistic when business-friendly Republicans are in the office to the point their optimism raises market prices," Pearkes said.

That said, there are signs that the market is cooling after its breathless run-up.

"Technical indicators, such as market internals suggests momentum is fading globally, not just in the U.S. Odds are pretty high that stocks will consolidate a little in the short term," Pearkes said.

Read: Here's why one chart watcher says the stock market is finally ready for a pullback (http://www.marketwatch.com/story/heres-why-one-chart-watchers-says-the-stock-market-is-finally-ready-for-a-pullback-2017-10-23)

In fact, an unscientific Twitter poll conducted by MarketWatch's Ryan Vlastelica shows more market participants are expecting the S&P 500 to see a 3% pullback before fresh all-time highs.

(https://twitter.com/RyanVlastelica/status/928670169353867266)

What's on deck for the week?

Corporate earnings

More than 90% of large corporations in the S&P 500 index have reported quarterly results, but there are still a few dozen companies that will report financials next week, including foods company Tyson Foods Inc. (TSN), a number of well-known retailers including L Brands Inc. (LB), Target Corp. (TGT), Best Buy & Co. (BBY), Gap Inc. (GPS) and Wal-Mart Stores(WMT), as well as tech company Cisco Systems Inc. (CSCO).

(END) Dow Jones Newswires

November 11, 2017 08:01 ET (13:01 GMT)