Investor Sentiment: Spotting Market Trends Before They Break

Investor sentiment is the key driver of all markets until it reaches extreme levels when it often serves as a warning sign of an impending trend change. The accompanying chart, which illustrates household (retail) exposure to the stock market since the 1950s offers some pointed lessons for investors.

A recurring theme of our posts is the importance we attach to extremes of market behaviour for their ability to provide clues to future market trends. The accompanying chart provides a number of examples of the value of measuring household equity exposure to assess the risk profile of the stock market.

Household exposure reached a high in the early 1970s at the peak of the fabled Nifty Fifty market before falling sharply during the severe bear market that followed the bursting of the Nifty Fifty bull market. Retail exposure fell steadily before bottoming coinciding with the start in 1982 of the great bull market that ended with the bursting of the Internet Bubble at the turn of the century (which also marked a top in retail participation).

We now find ourselves at a new high point for retail participation in the stock market.

What to do?

The extreme current retail bullishness (aka complacency) should be interpreted as a warning sign that the risk/reward proposition of stocks is not attractive. However, markets can rise or fall longer than seems reasonable, and experience has taught us to trust market price action to confirm trend changes above all other measures.

Therefore, retail enthusiasm for stocks should serve as a warning sign to be attentive for evidence of a trend change, but to avoid entering or leaving trends prematurely one should wait for the evidence provided by price action.

Investors can interpret what constitutes sufficient evidence to confirm a change of trend in many ways. We have developed a group of technical tools that have proved reliable that we share with subscribers in our paid service, the Global Investment Letter.

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