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Is the Contrarian Bell Clanging for Stocks?

At some point, investors will stop looking at the bright side.

John Rekenthaler, 01/27/2017

Sentimental Feelings 
Let's start with the caveat: There is no proof that investors can profit by considering market sentiment.

Betting against current sentiment makes intuitive sense. If equity investors are happier than usual, the process of reversion to the mean suggests that their mood is likelier to worsen than to brighten, causing stocks to suffer accordingly. Conversely, if shareholders are gloomy, the odds favor improvement. Eighty years ago, John Maynard Keynes discussed how "mob psychology" affected stock prices. Surely, it still does.

Profiting from that pattern is tricky, however. One can measure company earnings or bond yields, but not investor sentiment. There exist various proxies, such as consumer-confidence indexes, short-interest calculations, or the Shiller CAPE Ratio, that indirectly attempt to assess sentiment. Several of those indicators appear to have modest predictive power, in the sense that their output is loosely correlated with future stock market returns, but the results have not been statistically significant.

That said, I can't help but to pay attention. Today, I am reminded of a time nearly 20 years back.

The Y2K Specter
In late 1999, investors feared the "Y2K" bug--computers that had been coded to represent dates with two digits rather than four, so that the upcoming shift to the year 2000 would be indistinguishable from 1900. Some believed that this problem was so widespread, and the ripple effects from the upcoming misdating so large, that global communications would suffer major, long-standing problems. Stock market pundits were concerned.

Several times in autumn 1999, I was interviewed about the next year's investment prospects. The conversations went something like this:

Reporter: "Is now a good time for investors to consider selling technology?"

Straight Man: "The same as any other time, I suppose."

is vice president of research for Morningstar.

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