What is Investor Sentiment Telling Us?

The funny thing about confidence is that it can turn on a dime in markets, and environments with sour sentiment produce strong returns for stocks.  Today, things feel worse than they are.  There is really nothing structurally wrong with the United States, whether this feels true or not.  The US still ranks near the top of every list that matters when it comes to economic growth - the quality of our institutions, rule of law, economic freedom, ease of starting a business, etc.

Of the hundreds and hundreds of indicators that we have looked at, almost all of the popular economic ones either don't forecast stocks or if they do, the results are the polar opposite of what you would expect.  If we were to make a wish for a super strong bull market in stocks, you would also unconsciously be wishing for the things that tend to go along with them - a bad jobs market with lots of unemployment, big government deficits, and a nagging feeling in the pit of your stomach that our best days are behind us.

Case in point is the Rydex Ratio.  The current sentiment readings measured by our Rydex Ratio alone suggest a strong move higher with limited downside over the next 12 months.  The 17-year-old Rydex Ratio, which measures investor sentiment by looking at assets in Rydex's levered mutual funds, is arguably our single best psychology indicator as Keith mentioned last week.

Click image to view larger chart.

On Friday's close, the reading was -4.7%.  Readings below zero mean more bearish bets are being made by Rydex investors, and that is traditionally bullish for stocks.  Twelve months after negative readings like today, the market climbed an average 22%.  But we need to look at monetary conditions and the market's valuation if we want to know whether a simple below zero reading might turn into a -40% reading.

If we look at those periods where Rydex was negative, and monetary conditions and market valuation were average or better (today they are excellent), stocks were higher 99% of the time over the next 12 months by an average of 23.7%.  This is more than twice the average 12 month total return of 10.3% over the period.  The downside was limited too with the worst outcome a decline of 3.3%.

Why this indicator is not followed as religiously as jobs numbers by investors eludes me.  Its record is dramatically better, but no matter - the investment world's ignorance can be your gain.

Mark Dodson

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