Tuesday, December 18, 2018

From the Desk of David Burks: Could Extreme Negative Market Sentiment Offer Possible Hope to Investors?

David Burks
Author position
Sr. Vice President | Equity Income Analyst

From the Desk of David Burks

Hilliard Lyons Senior Vice President and Equity Income Analyst David Burks has been with the firm since 1983. He has been nationally recognized for his stock recommendations eleven times: seven times by Thomson Reuters and four times by The Wall Street Journal. David has appeared regularly on CNBC over the years.

Could Extreme Negative Market Sentiment Offer Possible Hope to Investors?

This long, miserable fourth quarter for the stock market is thankfully drawing near an end. It certainly can’t finish soon enough for beleaguered investors who’ve endured a large, broad pullback in all the major averages the past three months. This hasn’t been just a bad quarter; it’s the worst quarter we’ve experienced since 2011. The Standard & Poor’s 500 index has declined 12.6% this quarter and the average stock is off about 20% from its highs. While the month of December is historically the best performing month of the year, this month’s start is the worst since 1931. The S&P 500 and Dow Jones Industrial Average are off 7.6% and 7.8%, respectively. In addition, the DJIA has experienced daily declines of more than 100 points 20 times since October 1.

However, we’d like to add a little context and some potential encouragement. While the stock market has fallen sharply the past few months, it is only slightly lower from where it was trading this time last year. As of December 17, the Dow stood at just 3.7% below the same date last year despite this recent brutal sell-off. Is this disappointing? Yes, especially given that the Dow recently posted a new all-time high at the beginning of October. But does this represent some type of financial crisis, in our view? No, we do not believe that it does. Rather, it appears to be more of a painful correction, which is quite normal even if difficult to absorb.

On a more positive note, we are encouraged from a contrarian perspective by the extremely negative sentiment currently surrounding the stock market. In the way of background, from each week since 1987, the American Association of Individual Investors publishes a survey of how investors feel regarding the overall stock market. Every week thousands of investors across the country submit their opinions and can choose among three categories: Bullish, Neutral and Bearish. This survey is a valuable tool to gauge current market sentiment.

Well, investors right now are decidedly negative. Not surprising given the exceptionally poor performance of the market this fall and December in particular. Concerns regarding continuing trade tensions with China and potentially slowing global and domestic economic growth are the biggest investor fears. This sharp market decline has significantly soured investors on stocks. For the week ending December 12, just 20.9% of investors classified themselves as bullish. This represented a major 17 percentage point collapse in just one week. A decline of this magnitude in one week is a rare occurrence.

By contrast, the percentage of investors who classify themselves as bearish jumped sharply to 48.9% from 30.5% the previous week, the highest level of pessimism since April of 2013. This marked a dramatic increase of 18.4% who now view the market negatively. Thus, there now exists a very large 28 percentage point gap in the number of investors who are bearish compared to those who are bullish.

Why do we mention these figures? We do so because we feel investor sentiment at extremes can sometimes prove to be an effective contrarian indicator. In fact, we saw evidence of this earlier in 2018. In January of this year the number of investors who were bullish reached nearly 60%, the highest level since 2011. This spike in bullish sentiment followed a very strong start to 2018 in the stock market. We also remember what happened next: a sudden and very sharp stock market correction.

We believe that whenever investor sentiment reaches an extreme, whether positive or negative, the market is more likely to move in the opposite direction. In effect, it appears that the pendulum has swung sharply in the negative direction and, as a result, could potentially move back the other way at some point. The last time bullish sentiment was this low was the week of May 26, 2016, when bullish sentiment stood at just 17.75%, which was nearly thirty-one months ago. On that day the Dow Jones Industrial Average closed at 17,828. Interestingly, and while not an indicator of future results, by the end of 2016, the Dow had climbed to 19,762, an impressive advance of 10.8% in just over seven months.

We’re not saying that the market is necessarily poised for a sharp move higher. However, history tells us that when sentiment goes to one extreme, investors may want to position themselves for the market going the opposite direction. In our view, this recent plunge in investor sentiment potentially may be setting the stage for a meaningful market rebound. While we offer this observation as a glimmer of hope during a difficult period, that doesn’t mean both the market and investor sentiment can’t continue to decline. They certainly could and might well do so. Yet we feel that the lower they go, the greater the chance of an eventual market reversal. While stock market corrections are clearly painful, we encourage long-term investors to maintain their equity positions in pursuit of their long-term financial goals—or that they consider adding to existing positions or establishing new ones.



Each client’s investment needs, risk tolerance, and goals are different. This newsletter is not meant to be advice for any specific investor. Nothing in it should be construed as an offer to sell, or a solicitation of an offer to buy, any securities. This should not be used as the sole basis for an investment decision. Any opinions or estimates are subject to change without notice. For information about how any of this information applies to your personal financial situation, please contact your Wealth Advisor.

Past performance is not a guarantee of future results.

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All investing involves risk, including the possible loss of principal. You should carefully consider investment objectives, risks, charges, and expenses of any investment before investing. Diversification and asset allocation do not guarantee a profit or guarantee against a loss.

Stock markets, especially foreign markets, are volatile and can decline significantly in response to adverse issuer, political, regulatory, market or economic developments. The bond market is also volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect can be more pronounced for longer-term securities.) Fixed income securities also carry inflation risk, liquidity risk, call risk, and credit and default risks.