MarketGrader Sentiment Index At All-Time High, Suggests Investors Proceed With Caution

by: MarketGrader

With the U.S. stock market at or near 52-week highs, depending on which benchmark you look at, and an uneasy complacency among investors seemingly setting in, we thought an update on our MarketGrader Sentiment Index might serve as a reality check. For those not familiar with the index, or MGSI as we call it, we suggest a quick read of our October 5th, 2011 introductory post, available here.

To summarize: MGSI tracks the ratio of stocks in the MarketGrader.com coverage universe with a positive sentiment to those with a negative sentiment. Such ratings are based on our four sentiment indicators that track price momentum, price trend, earnings guidance and short interest. Any reading of the MGSI ratio above 2.5 suggests excessive investor optimism, while a reading below 1.5 suggests excessive pessimism. Extreme readings above 3.0 or below 1.0 suggest extreme scenarios. Which brings us to our current state of affairs.

Before discussing what MGSI is saying today it is worth noting how we got to our current state of collective enthusiasm for stocks. Since our October 5th warning of an extreme reading of 0.14 (with seven stocks in negative sentiment territory for each one with positive sentiment) the market has rallied strongly as the risk premium in risk assets has fallen significantly. Since our article, the S&P 500 Index has gained 20.8% with the Dow up 19.4%, the NASDAQ Composite up 23.1% and the Russell 2000 up 28.0%. We'll take this opportunity, of course, to highlight the performance of the MarketGrader-powered Barron's 400 Index, up 29.2% since Oct. 4th 2011. In rising periods such as this one the B400 clearly continues to outperform.

Perhaps more telling than the rise in these benchmarks has been the fall in the VIX, the now ubiquitous measure of implied volatility in S&P 500 options, which closed Thursday 53% below its Oct. 4th level.

This forceful rise in equities in the last four and a half months has expectedly pushed the MGSI to an all-time high of 4.96, solidly in what we call "Extreme Optimism" territory. Today there are 1,175 stocks in MarketGrader.com with positive sentiment and only 358 with negative sentiment. To put this into perspective, since MGSI's inception in November 2008, the index has spent only 20 days above 3.0 and three days above 3.5. And this rise has been powered by stocks across the board, as seen from our individual sector MGSI sub-indexes. These essentially track the same ratio of positive-to-negative sentiment stocks MGSI tracks but on a sector by sector basis across nine sectors.

Of all nine MGSI sectors tracked by MarketGrader, seven are currently scoring above 2.5, inside our "Excessive Optimism" territory. Six of the seven currently score above 3.o, inside of our "Extreme Optimism" area. These are all at 52-week highs. The seventh, Energy, is not at a yearly high but is only a stone's throw away from getting there. The sector with the most extreme reading is Financials with an off-the charts MGSI level of 9.61. Of the 15 stocks in the sector with a sentiment score above nine (out of 10) only three have a 'Buy' rating based on underlying company fundamentals.

The only two sectors not in the overly optimistic camp are Telecommunications, which only counts a very narrow 109 companies and Materials, a somewhat broader group. Telecommunications, at 0.88, is actually in "Extreme Pessimism" territory and Materials, at 2.11, is in neutral, or 'Goldilocks' territory, not too hot, not too cold.

The MarketGrader Sentiment Index readings should be seen as tactical, rather than strategic market calls, considering they are based on a very narrow view of the market, namely through investor sentiment. Investors should place the MGSI readings in the context of macroeconomic trends and overall earnings-driven trends for U.S. companies. From the perspective of company fundamentals we feel generally bullish about the case for equities in the years ahead, particularly given the lack of earnings multiple expansion despite the aforementioned increases in stock prices.

With three quarters of the S&P 500 and 83% of the Barron's 400 companies having already reported results this earnings season, both indexes are still trading at below historical P/E ratios of 13 and 14 times 12-month forward earnings respectively. And while corporate earnings gains have slowed down from the early 2011 pace, U.S. companies continue to show productivity gains and are sitting on piles of cash and mostly sound business models. This will, however, be the subject of a separate story. For now cautious investors might want to keep an eye on MGSI, available for free here.

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