Current Economic Conditions Explained 3: Sentiment

We’ve all heard the predictions of financial doom lately, including both financial institutions and, more recently, the automobile industry.

In an effort to add a note of reason to this conversation, this is Part III in a five part series where we will look at current economic data, with an explanation of what it may mean for the future. In part one, http://www.socyberty.com/Economics/Current-Economic-Conditions-Explained-1-A-Five-Part-Series.376083, we discussed Economic Cycle Momentum.

In part two http://www.bizcovering.com/Investing/Economic-Cycle-Explained-Part-II-Monetary-Indicators.385567, we discussed Monetary Indicators. In this third part, we’ll discuss Sentiment.

Part 3: Sentiment

In a previous article earlier this year http://www.bizcovering.com/Investing/Feeling-Panicked-Think-Again.301729, I noted that of all the twenty-one economic indicators I follow, Sentiment is by far the most reliable indicator.

Sentiment is the measurement of optimism for future market performance. This measurement, however, is a negative corollary to actual market performance. For non math geeks, that means that the more positive sentiment is, the more negative this indicator is for the market.

Investors as a whole tend to act irrationally as market investors. The two basic motivating emotions are fear and greed. When greed is the predominant sentiment, the price paid for stock is secondary to the feeling that someone else will pay yet a higher price, and the capital market equivalent to a feeding frenzy ensues. Buyers push prices to ridiculous levels. This phenomenon is known as a bubble, and occurred most recently in the housing market. At times like this, market sentiment is very positive (measurements of 70 – 90), and prices are unsustainably high. Positive sentiment = bad time to invest.

Over time, some event will pop the bubble, owners will sell in a panic to a dearth of buyers, pushing prices lower and lower, until an equilibrium occurs that results in rational pricing.
Times like this, when fear is the predominant emotion, buyers hesitate to participate in the market, frightened of still more downturn, susceptible to bad news and scared to buy. Sentiment is very negative (25 – 40), and prices are ridiculously low. Negative sentiment = good time to invest.

I used to joke with my colleagues that I chose the only profession where nobody wanted to buy when there was a sale. There was a BIG sale in the mid-1970’s (when Warren Buffett bought stock in many of the companies that made him a multi-billionaire), in the early 1980’s, 1987, 1992, 2001 and now. This makes the others pale in comparison.

Am I saying to invest now? No. I am saying only that the most reliable economic indicator I have watched for 30+ years is as negative as I have ever seen it.

And, by the way, Warren Buffett, a notoriously secretive investor, is publicly saying that he’s aggressively buying stock.

You can draw your own conclusion, and while you’re doing that, wait for part four in this series – Valuation. Happy Holidays!