Investment Contrarians

What Investor Confidence Is Telling Us About the S&P 500

By for Investment Contrarians |

Investor Confidence Is Telling Us About the S&P 500There are various measures to determine investor sentiment regarding the general market. The most obvious is to take a look at a broad index, such as the S&P 500, and see where it’s currently trading. Because price is truth, the market does not lie. If people are bullish or bearish, their actions in buying and selling shares within the S&P 500 will be translated into corresponding price moves.

However, it is interesting to look at corollary indications to determine how strong the underlying trend really is. Investor sentiment is extremely difficult to predict, as is anything in life. While the future is unknown, by understanding the strength of current investor sentiment, we can help form a picture about what the future holds for the S&P 500.

State Street has an Investor Confidence Index, developed by Kenneth Froot, a Harvard University professor, and Paul O’Connell of State Street Associates. According to State Street, “The State Street Investor Confidence Index measures investor confidence or risk appetite quantitatively by analyzing the actual buying and selling patterns of institutional investors.” (Source: State Street, last accessed January 14, 2013.)

Let’s take a look at this metric of investor sentiment in relation to the S&P 500.

For the month of December, the Investor Confidence Index moved upward, just slightly higher than November, which was the low of 2012. Professor Froot commented, “As has been true for some months now, global institutional investor confidence remains weak as institutions continue to shy away from equities.” (Source: “Investor Confidence Index rises slightly in December by 0.4 to reach 80.9,” State Street, December 26, 2012, last accessed January 14, 2013.)

S&P 500 Large Cap Index Chart

 Chart courtesy of www.StockCharts.com

This is a three-year weekly chart of the S&P 500. As is obvious, since the lows of 2010 in this chart, every major downward move has been a good buying opportunity. We are currently at the highs for the S&P 500 over the last three years, yet investor sentiment as measured by State Street is very low.

In 2010, investor sentiment as measured by State Street’s Consumer Confidence Index bottomed in September and October (at approximately 88.1 and 88.2, respectively), which was then followed by a strong upward move in investor sentiment in December, ending the year with an investor confidence reading of 104.2. The S&P 500 also ended on a high note in 2010. (Source: “Investor Confidence Index Historical Data,” State Street, last accessed January 14, 2013.)

In 2011, the S&P 500 had a massive selloff during the June to September period. This resulted in a decline in State Street’s index on consumer sentiment, dropping from 102.5 in July to 88.1 in August, which was the low of the year. State Street’s investor sentiment index rebounded and hit 99.4 in November even though the S&P 500 sold off. Eventually, the S&P 500 did rally and it recouped some of the losses made earlier in the year.

So, looking at these data, it might seem that State Street’s Investor Confidence Index might show underlying strength or weakness related to the S&P 500.

Then we get to 2012.

The S&P 500 sold off in May and into June. The Investor Confidence Index moved up from May’s reading of 86.5 to June’s reading of 93.3, a substantial move upward. The S&P 500 then moved higher in the July to September period.

While the S&P 500 peaked in September, the Investor Confidence Index peaked in July and dropped consecutively in August, September, and November, hitting its lows.

In 2012, it looked like this investor sentiment metric led the S&P 500. However, the S&P 500 has staged an extremely strong rally into the year-end, while the Investor Confidence Index is only at 80.9 for December, near the lows of the year.

In fact, going back to 2003, this reading of 80.9 for December is the lowest level since 2008’s reading of 82.8.

What does this mean?

First of all, correlation does not mean causation, meaning that just because two items are correlated does not mean one causes the other.

However, there is something to this reading. What it tells me is that large institutions have exited the markets and are sitting on the sidelines. Perhaps all of the talk regarding the fiscal cliff has led to underinvestment in the S&P 500 as investor sentiment was clearly cautious at the end of 2012.

The question: are large institutional investors correct in being cautious with their investor sentiment, or will they be forced to pile into the market and push the S&P 500 even higher?

The investor confidence reading hit its previous lows in December 2008, just as the S&P 500 made its multi-year lows in March; it has more than doubled since that point.

By looking at the S&P 500 technically, this type of formation usually leads to a positive burst upward through resistance. As each low has been subsequently higher than the previous low, this is a technically bullish market.

If investors feel they’ve missed the boat in the S&P 500 as it continues higher, at some point, they will capitulate and be forced to reallocate funds into equities. On the other hand, perhaps institutional investors are correct in believing that the market is overvalued.

I think a lot of large investors are waiting for earnings season to be completed to get a better picture of how the S&P 500 companies will fare this year. This type of clarity will help form investor sentiment, not only for next quarter, but perhaps also for the remainder of 2013.

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