Why Plunging Investor Sentiment and Consumer Confidence Index Aren't Cause for Concern

by: Tom Madell

It has never been easy for anyone, expert nor amateur alike, to predict the stock market's next likely direction. But that doesn't deter most people from thinking they can put their finger in the wind and get a sense of where things are headed.

Right now, one might assume that there are such strong pulls in a negative direction that it could easily lead many people to become considerably pessimistic about what lies ahead. But if this describes you, you should keep in mind one extremely important fact: Investor sentiment, that is, how investors tend to feel about the near term prospects for the stock market, is a trailing indicator, rather than a leading one. By definition, a trailing indicator cannot foreshadow the future; only a leading one can do that.

Just as pain follows being punched, so as the market shows signs of weakness, the majority of investors turn negative and report that they increasingly do not feel confident that stocks are going to deliver good future returns. But given the inevitability that many investors will turn glum under such circumstances, I certainly would not suggest either a) stretching that feeling into a conclusion that the stock market is now more likely than not to deliver poor upcoming performance, or especially, b) assuming that long-term investors will wind up suffering. But many investors are apt to do just that.

According to the American Association of Individual Investors (AAII), their weekly Sentiment Survey shows that as of 6/8, more investors are Bearish (47.7%) than Bullish (24.4%); the rest are Neutral. (See here for the latest figures.) According to their data, the long-term average is for investors to be more Bullish (39%) than Bearish (30%), so the current Bearish figure appears to be a quite strong negative result.

But because investor sentiment is merely a trailing indicator, it really tells us nothing about where the market might be headed; rather, it merely reflects that even sophisticated investors will mark down their expectations for the market based on a variety of data, including the market's relatively short-term prior performance.

In fact, studies show that the more extremely Bearish investors become, the greater the chance that the market will actually improve. As pointed out on the AAII website,

History shows us that more times than not the market will go against the majority. ... By following market sentiment indicators, you may be able to pick out market tops and bottoms. In other words, investor sentiment may be used as a contrarian indicator for the overall market. [Italics added]

(Note: a contrarian indicator means one that suggests you should go counter or contrary to the prevailing sentiment of the majority. Thus, negative sentiment is more predictive of better stock market performance ahead, and vice versa.)

Who are the investors who participate in the AAII survey? Once again, according to information on their website, only members of AAII can vote and such members are in the "upper echelon of active, hands-on individual investors" many of whom "have an investment portfolio of at least $500,000." Given this, perhaps a simple explanation of the above apparent contradiction is that too much knowledge of data can lead investors to overweight negative information in forming a judgment of where the stock market might be headed.

Of course, another possible explanation as to why these investors are likely to be wrong would be that once a large number of investors are negative, most of their selling of stocks would have already occurred; when investors throw in the proverbial "towel," the main thrust of the market becomes governed by bargain hunters seeking to grab those stocks at levels that appear to them to be low. A final possible explanation that we particularly favor is that the threat of losing money is so strong that it can easily affect attitudes and expectations of the future more than would be the case if investors were able to make such judgments in a less emotionally-laden environment.

Unfortunately too, from my perspective, investors are notoriously fickle in how Bullish or Bearish they are. In other words, it does not take too much in the way of data or elapsed time to get people to change these relatively short-term judgments.

As an example, two months earlier on April 7, investors were considerably more Bullish (43.6) than Bearish (28.9). During the ensuing period, they have mainly become increasingly Bearish. So had you thought as these investors did back in early April, you would have likely been moderately confident, only to have been tempted to reduce your stock market exposure now. But, lest you think that sentiment truly switched between then and now, 3 weeks before that survey, on March 17, they would have been not very Bullish (28.5) either. So, apparently, Bullishness and Bearishness can bounce around considerably, and even flip-flop completely over a very short period of time. (See these weekly changes here.)

This means that trying to base longer-term predictions, either optimistic or pessimistic, on what the average investor thinks from week to week (or perhaps even your own changing sentiments), would regularly push your opinions about the stock market's prospects either considerably up or considerably down. We do not think this is a good way to invest. We think it is better to have a fairly steady opinion that hardly changes from week to week or month to month, but more likely, only in intervals of perhaps 6 months to a year, or even longer.

If we look more broadly at how the general public looks at the economy, rather than just the AAII focus on the direction of the stock market, we find that, once again, interpolating prolonged negative survey results as continuing to suggest poor future trends may be more like using a rear view mirror rather than a useful forward-looking predictive tool.

The Conference Board, a world-renowned data-providing organization, reports a monthly Consumer Confidence Index (CCI) attempting to measure ordinary households' appraisals and expectations about the economy. Specifically, five judgments are elicited: current business conditions and those expected in 6 months, the same for employment conditions, and finally, expectations for total family income six months hence.

In the past, when the CCI has consistently plunged, this has coincided with the economy falling into recession, so in that sense, its scores have mirrored the overall economy. However, by the time the Index was at its lowest level, the recession was already over, or just about to be.

This May, the Consumer Confidence Index fell to 60.8 from a revised 66.0 in April, although for the most part, it has been rising from a highly depressed level since early 2009 which also corresponded to near the end of last recession. (Note: A value of 100 is considered the baseline, although it has averaged closer to 90 since the CCI was created in 1977. See the chart here for the long-term picture.)

There have been only two other prolonged periods since 1980 when American households were about equally negative in their attitudes about current and future economic conditions as they are right now: in the early 1980s and in the early 1990s.

In early 1980, the Index fell precipitously below 80 and remained there until early '83. In mid-1990, the same happened and it stayed there until early '94. The current extended drop began in early '08 and has persisted through the present time. (Note: Any reading below 80 signals a worrisome dip in confidence, according Conference Board researcher Lynn Franco. In 2003, it also dropped below 80, but rebounded in less than a year.)

In each of the 3 prolonged drops, stock prices did suffer but began recovering well before confidence returned above 80. In each case, in spite of the 3-plus long year bout of consumers being very pessimistic, the stock market came to look past the low confidence levels and give investors who took a contrary position excellent returns.

While it is uncertain if and when the Consumer Confidence Index will climb back over 80, history suggests that it too is a lagging indicator. Low scores mainly show where the economy has been, not where it is going. (It hit its record low of 25 in Feb. 2009 which almost mirrors exactly when the stock market hit its bear market bottom in March '09). And given the usual propensity of the economy to be cyclical, a prolonged period of low marks for the economy almost always has been followed by a turnaround in the not-too-distant future.

Taken together, the current low readings for both investor sentiment and the CCI show that the American public is highly pessimistic about current conditions and what may lay ahead over the next 6 months. This, I'm sure, includes many of you reading this article. However, based on the evidence I have presented above, all this may go to show is that, likely, whenever you, and especially others in the country, are getting that sinking feeling, you should take a time out to reflect.

Carefully consider whether this rampant feeling may be a sign that the stock market is already about sold out by those worried investors, and whether or not there are enough remaining positive things about our slowly recovering economy to justify the view that stock prices are already low enough to be a reasonably safe bet going forward. If so, the plunging attitudinal data, rather than being a cause for extreme worry, more likely indicates that better not worse, days lie ahead.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.