Systematic Relative Strength

Everyone wants to know the answer to this question, and every commentator, it seems, has an opinion. We examined S&P 500 price data going back to 1950 and this is what it shows:

There were 46 10% corrections since the beginning of 1950. Out of those 46, 12 of them turned out to be 20% corrections. About 25% of the time a “correction” turns into a “bear market.”

(This is using the now media-standard 10% drop is a correction and 20% drop is a bear market.) In any one case, no one really knows whether a drop is just a short-term correction or the beginning of a bear market. All of the forecasts you have read or seen over the past few days should properly be labeled “guesses.” We wouldn’t even hazard a guess as to the eventual outcome of the current drop, but it is interesting to note that 75% of the corrections since 1950 did not result in a bear market. Most of the time, the correction is contained in the 10-20% range and the market bounces back.

Advisors, however, appear to be gambling heavily on the bear market scenario. Mark Hulbert reports that a rush is on to jump on the bearish bandwagon. Commentaries like this one from Investment Advisor magazine are pretty common. Investment News also reports that advisors are making a mad dash to cash. Based on the historical statistics, there is a certain amount of risk in moving to cash, especially since advisors seem to be driving the change:

Most of the advisers who are moving into cash are doing so on their own, and not as a result of client demand. Just 14.9% of advisers in the InvestmentNews survey who said that they recently moved into cash said they were doing so in response to requests from clients.

In other words, clients are not the ones running to cash. Clients may be quite unhappy if the move to cash does not work out. Even if the clients were driving the change, they might end up blaming their advisors for it-but if it was the advisor’s idea, well, that’s pretty cut and dried.

Of course, advisors could be right and earn clients’ undying gratitude. It’s just that sudden swings to bearishness are often signs of a rally rather than an indication of continuing weakness. Right now the jury is still out. It’s too early to declare victory either way, but allocation changes in response to market swings ought to be considered carefully. No advisor wants to cry wolf too often.

Our latest sentiment survey was open from 5/21/10 to 5/27/10. The response rate continues to tick higher as we roll out more surveys – this week we had 191 responses. Your input is for a good cause! If you believe, as we do, that markets are driven by supply and demand, client behavior is important. We’re not asking what you think of the market—since most of our blog readers are financial advisors, we’re asking instead about the behavior of your clients. Then we’re aggregating responses exclusively for our readership. Your privacy will not be compromised in any way.

After the first 30 or so responses, the established pattern was simply magnified, so we are comfortable about the statistical validity of our sample. Most of the responses were from the U.S., but we also had multiple advisors respond from at least two other countries. Let’s get down to an analysis of the data! Note: You can click on any of the charts to enlarge them.

Question 1. Based on their behavior, are your clients currently more afraid of: a) getting caught in a stock market downdraft, or b) missing a stock market upturn?

Chart 1: Greatest Fear. 92.7% of clients were fearful of a downturn, up significantly from last survey’s 84.0%. Only 7.3% were afraid of missing an upturn, also much lower than last survey’s 16.0%. Recent market action has driven market fear to the highest levels we have seen yet in our survey. This is great news for the purposes of our data-driven survey, but bad news for the respondents’ collective blood pressure readings!

Chart 2. Greatest Fear Spread. Another way to look at this data is to examine the spread between the two groups. That spread has continued its surge from 2 weeks ago, moving to 85% from 68%. Again, these readings indicate that fear is dominating investor emotions at this point. After 2008, investors seem very afraid to stick to their guns during any type of correction. Chart 2 is constructed by subtracting the percentage of respondents reporting clients fearful of missing an upturn from the clients reported as fearful of a market downdraft.

Question 2. Based on their behavior, how would you rate your clients’ current appetite for risk?

Chart 3: Average Risk Appetite. The average risk appetite this week was 2.34, another noticeable move lower from last survey’s average risk appetite of 2.55. This chart shows that client risk appetite is moving lock-stop downwards with the market. It will definitely be interesting to see how this major pullback will shake out – and how clients’ risk appetites will react. This question is designed to validate the first question, but also to gain more precision and insight about the reported risk appetite of clients.

Chart 4: Risk Appetite Bell Curve. This chart uses a bell curve to break out the percentage of respondents at each risk appetite level. Right now the bell curve is biased to the low-risk side, even more so than the last five sentiment surveys. In our office discussions, we’ve talked about what the underlying meaning of this risk appetite might be. It’s interesting to see how the average risk appetite and the greatest fear don’t seem to correspond. For example, the Greatest Fear spread right now is huge – 93% versus 7% are worried about getting caught in a downturn. It would seem to follow that the average risk appetite would be even more skewed towards 1, but that’s not the case. Perhaps we have a situation where the clients are extremely fearful of the market, but also don’t want to lose out on an up move…hence a large percentage of conflicted 1′s and 2′s. Something to think about.

Chart 5: Risk Appetite Bell Curve by Group. The next three charts use cross-sectional data. This chart plots the reported client risk appetite separately for the fear of downdraft and for the fear of missing upturn groups. We would expect that the fear of downdraft group would have a lower risk appetite than the fear of missing upturn group and that is what we see here.

Chart 6: Average Risk Appetite by Group. A plot of the average risk appetite score by group is shown in this chart. The fear of missing downdraft group had an average risk appetite of 2.24, while the fear of missing upturn group had an average risk appetite of 3.50. Theoretically, this is what we would expect to see. The fear of downdraft group’s risk appetite fell even further from the last survey, while the fear of missed upturn group’s risk appetite actually went up! This might be because there were so few people in the upturn group that one or two outliers heavily skewed the average.

Chart 7: Risk Appetite Spread. This is a spread chart constructed from the data in Chart 6, where the average risk appetite of the downdraft group is subtracted from the average risk appetite of the missing upturn group. The spread is currently 1.26, as the spread continues to grow with a weakening market. Theoretically, a market bounce will bring that spread lower, while more downward momentum could lead to an even larger spread. Only time will tell.

The market action in May has been absolutely brutal for client sentiment. The popular VIX indicator, a measure of fear in the market, spiked to one-year highs on May 21, the date this survey was launched. It’s very clear that our sentiment survey is matching up fairly well with the VIX indicator, which could be a sign of good things to come in the market. No one can predict the future, as we all know, so instead of prognosticating, we will sit back and enjoy the ride. A rigorously tested, systematic investment process provides a great deal of comfort for clients during these types of fearful, highly uncertain market environments. Until next time, good luck and thank you for participating!