Systematic Relative Strength

Our latest sentiment survey was open from 6/4/10 to 6/11/10. The response rate remained near its all-time highs, right at 183 respondents. 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. 89.1% of clients were fearful of a downturn, just a hair lower than last survey’s reading of 92.7%. The market action of the last month has pushed investor sentiment to very bearish, pessimistic levels. Investors are exhibiting extremely fearful behavior. Only 10.9% of clients were concerned about missing an up move, just slightly higher than last week’s readings of 7.3%. The fear in the market is palpable, indeed!

Chart 2. Greatest Fear Spread. Another way to look at this data is to examine the spread between the two groups. Again, we are seeing very high levels of fear evidenced in the size of this spread, which fell slightly from 85% to 78%. 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 for this survey round moved even lower, from 2.34 to 2.18. Again, we are seeing clients’ fear trumping any type of opportunity cost, as the average risk appetite moves lock-step with the market lower. The question to ask here is how low is too low? Using only the data inputs in this survey (discounting any daily noise), the market is down about -12.5% from the recent peak. That’s not particularly unusual. Our data shows that since 1950, only one out of four -10% market corrections become full-blown bear markets (-20%). The historical record suggests that a correction is the more likely scenario. 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 any of our other sentiment surveys. What we see in the bell curve is just more evidence that clients are afraid of losing money in the market. The heavy concentration of 2’s and the complete lack of any 5’s both paint a picture of a market dominated by fear.

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. Something stands out in this bell curve compared to last week’s (link here) – note the swing of the missing upturn group from high risk appetite to low risk appetite.

Theoretically, the missing upturn group is going to have a higher risk appetite, but this survey’s chart shows an extreme move from higher risk to lower risk. It’s a bit of a disconnect, because if you report that you are more concerned about missing an upturn, you would theoretically want more risk. However, we are seeing zero 5’s and a high concentration in 2′s and 3’s in that group.

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 2.11, while the fear of missing upturn group had an average risk appetite of 2.75. Theoretically, this is what we would expect to see. However, you can see that the missing upturn group’s risk appetite has fallen significantly since the last survey. It seems like the missing upturn group has a much more volatile risk appetite, which is evidenced in the swings of their average as a group. Does this group change their mind more than the other group? Maybe market sentiment swings are powered by only a portion of the participants. Something to think about.

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 .63, a significant move from last week’s reading of 1.26. This major move in the spread is a direct result of the missing upturn group’s shifting risk appetite. Two weeks ago, this group had a smattering of 5’s and 4’s with a concentration of 3’s. This week, we see 1’s and 2’s, with a concentration of 3’s. What does this mean?? It means that the missing upturn group has a more volatile risk appetite – they jump around and are conflicted about being in or out of the market.

May was a brutal month for client sentiment. We’re hovering near the all-time highs of fear since this survey began in March. The big story for this round of the survey can be found in the missing upturn group’s volatile risk appetite average. Is this upturn group just more emotional than the downturn group? Or is the downturn group more self-aware, and therefore less prone to change risk outlooks? When you consider that this survey is conducted twice a month, it seems like the risk appetites should remain more stable than what we have seen so far. The shift in the spread represents a significant change in client sentiment, but for long term investors, these types of emotional swings can lead to poor decisions and harmful results.

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 trading and thank you for participating!