America is Back Part II: The Stock Market

I was in my office working this afternoon when a young man came in to speak with me.  After talking about a few business related topics, he asked me how my 401k was doing.

"Pretty good," I said.

"Man, mine is doing fantastic," was his reply.  "I'm invested in a lot of high growth mutual funds, and my portfolio was up about 10% in just over 30 days."

Then he told me about some kind of green line that he follows on his fidelity investment screen.  The green line tells him when he will be able to retire, and how much income he'll be able to live on.

I told him that if his high growth/high risk mutual funds were to run into any problems, at least he was young enough to recover over time.

Then he got up to leave, and I don't think he even heard or understood the last thing I said.  Recover?  America has already recovered, he only needed to focus on that 10% growth over 30 days.

Besides, what does a real estate guy know about stocks?

I believe much of the discussion around America being back is based on the current price of the Dow Jones Industrial Average.  The DOW.  People assume the stock market is the best available tool to gauge the strength of the American economy.

There are times during history, however, when we have seen that the market is wrong.  Think back to just a few years ago during October of 2007 when the DOW crossed over 14,000.  18 months later the market was under 7,000.  So which was right, 14,000 or 7,000?

The only way to answer that question is to look at the two best determinents of future stock market direction: value and sentiment.  Last week I discussed value in Is The Stock Market Expensive?  Value is what long term fundamental investors use to pick stocks.  Guys like Warren Buffett.  They like to buy when stocks are cheap and stay on the sidelines when they get expensive.

So what would cause an investor to buy a stock when it is already expensive?  That is where the second determinent comes in which is sentiment.  We have seen throughout history that people make irrational decisions based on emotion when it comes to investing money.  They tend to follow the crowd, which pushes markets up and down past the point where a rational investor would buy or sell.

So how does this help us?

Because as an investor you can track the extreme sentiment in the market using various tools.  (Aside from people talking about their 401k)

One of those tools is the Daily Sentiment Index.  In the chart below there are two lines, the top line shows the DOW price and the line below it shows the Daily Sentiment Index.  Extremes on this index help traders know when they are close to a short term top or bottom.

For example, in March of 2009 the sentiment index clocked in at 2%.  That meant that 98% of investors at that time thought the market was going lower.  (The market has since risen 78% from that low)  Today we reached 92% optimism.  This means only 8% of investors think that the market is going lower. 

Other major sentiment indicators such as the put/call ratio, the advisor's survey, and the NYSE trin, are all painting the same picture:

Investors across the board all believe in mass that the market is headed higher.  They had the same time of sentiment during the spring of 2000 and the fall of 2007.

Now, just because a market is expensive and sentiment is at an extreme does not mean a market cannot get even more expensive and sentiment cannot get even more extreme.

It just means being in this market is purely a bet on momentum and speculation.  Or, maybe the economy will come back and justify these prices because after all:

America is back.