Investor sentiment: Looking inside the market’s mood swings

Let’s face it, 2014 is playing out about as nicely as we could expect, so far. The U.S. economy is gradually improving as evidenced by improved employment, increasing lending by banks, and the May 22nd, 2014 Markit U.S. Manufacturing PMI survey. Even global tensions in the Ukraine and South China Sea don’t seem to have rattled investors. Still, I have noticed an underlying note of caution among investors who otherwise seem content to ride along with the current market trend.

This was true even at our own recent 2014 Russell Institutional Summit, where one session in the client conference focused on liability-driven investments, which offer ways for investors to help “de-risk” their portfolios by selling equities once a certain outcome is reached and helping to hedge their liabilities with bonds. The room for that session was full, a clear signal that many of our investors are still embracing a prudent level of caution even as growth occurs. You can even see some of those same notes of caution in our own Strategists’ 2014 Global Outlook: second quarter update.

It raises a valid question: What role is investor sentiment likely playing in the current market, and when might that sentiment – either worry or optimism – swing the market in a pronounced direction?

Investor sentiment is more than an abstract hunch about market moods. Today it’s a tangible factor that plays an important role in the direction of the market. Moreover, we believe investor sentiment can be quantified and often used as a valuable indicator of where markets might go. Ignoring or downplaying sentiment can create a disservice to investors.

At Russell, we treat investor sentiment as one of three legs on which we build investing recommendations. The other two legs are investment valuations and business cycles. We start by designing and constructing portfolios based on desired investor outcomes. Then we manage a portfolio tactically and in real-time based on these three legs.  As a part of this approach, Consulting Director Mike Smith talks about sentiment and other cycles that play into investment recommendations in a recent Helping Advisors Blog post.

As part of this approach we use to build investing recommendations, we gauge investor sentiment by incorporating specific fund-flow metrics into our characterization of the investment landscape.  Additional information is gleaned from looking at trading volume and price movements.  We consider how optimistic or pessimistic people are in different scenarios. Think of it as a wind speed gauge that helps us evaluate the magnitude of tailwind or headwind.

We’ve also seen a weather pattern. Sentiment tends to follow a particular path, as markets rise and fall and as greed and fear oscillate in the marketplace. Here’s a chart that depicts what I mean:

Click to view full PDF of image

As you can see, we believe sentiment tends to have the most impact at the peaks and valleys, when investors’ euphoria or panic can drive a market higher or lower than rational analysis might suggest.

But, again like weather patterns, sentiment operates on its own schedule. Quarterly earnings announcements, employment reports, Fed meetings – all those can be anticipated and marked on a calendar. Investor sentiment can change suddenly and unpredictably, sometimes due to external factors unrelated to financial issues. Sentiment can become the market’s rogue wave, often adding volatility where none was expected.

Today, we think investor sentiment is about where it should be – in a state of cautious optimism. While it’s true equities aren’t cheap based on valuations, we still see some room for moderate growth through another 12 months or so. While recent jobs reports are good and inflation is moderate, many investors are tempering their hope for clear sailing with a vivid memory of recent difficulties. If we had seen empty seats at our Summit session on liability-driven investing, I might be more worried.