It’s Not Easy, But the Math is Simple:
by David Anderson
Wall Street pundits have developed many waysto measure investor emotions, as follows:
1) The Sentiment Indices are very heavy to the bearish side. As of July 7, the American Association of Individual Investors poll had 52.1 percent of its respondents bearish and only 23.9 percent bullish. Similarly, the Investors Intelligence index of pro-fessional investors had 44.7 percent bears and only 31.9 percent bulls. Both of these surveys are at favorable contrarian extremes.
2) Emotions are easily measured in the option market. Put/Call Ratios help us to judge whether investors, on balance, are cautious (i.e. put buyers), or enthusiastic (i.e. calls). The CBOE equity put/call ratio is considered overly pessimistic when it is above 0.6x(note-at mid-year it was 0.77x) and the Investors Business Daily’s computation is abnormally leaning to the put side(1.08:1, as of July 8), which is a sign that the market is poised to surprise on the upside.
3) Short—Interest is running well above its “normal” high levels (i.e. rarely above 10percent). Currently, 13 to 15 percent of the NYSE’s daily volume is represented by shortselling activity. This suggests that many less-seasoned market participants are “betting” on the downside. Anyway one chooses to view it these shorts must be covered.
4) A somewhat subjective (albeit pretty reliable) way to measure prevailing investor opinion is to analyze the covers of business magazines. Publishers attempt to appeal to the emotion ofreaders with the headlines. To do so, they focus on what is most dominant in the public’s mind. And, there is a remarkable record of cover stories appearing at major reversal points. For example, two years ago the prominent headlines espoused the virtues of real estate investing (at the top, of course). And, most recently, the July 7 edition of Barron’shad a growling bear on it.
The popular press seems to have finally arrived at the conclusion that this is a bear market because of the 20 percent decline from last October’s peak. However, since the median bear market has dropped 28 to 30 percent, and if the current down trend is not more sever than “normal,” it is already 70 percent complete (or, too late to panic?). In short, the flood of negative sentiment is so extensive that we’re inclined to believe that a 2H-2008 market rebound will develop.
Since 1960, the range of bear markets has been from a mild -21 percent in 1990 to -45 percent in 1973-74. Interms of duration bear periods have lasted anywhere from 2 months (1987) to 31 months(2000-2002). As of this writing, the S&P 500 at 1,252 was exactly 20 percent below last October’speak and has erased approximately $11 trillion of stockmarket wealth. We are seeing a third attempt to put a durable bottom in place over the last nine months (note: earlier lows were around the 1,270 level on Jan. 22 and March 10).
U.S. equity mutual funds have been dealing with serious redemptions during the 1H-2008 (i.e. worse than in the 2000-02 bear market). And, recently, foreign funds have started to see outflows, as well. It may be that the stock market will have one final, gutwrenching purge that will drive the volatility index (CBOE-VIX) back above 35. However, unless Wall Street’s most conservative earnings projections are off base, the current valuation of less than 14x consensus 2009 earnings estimates are offering compelling prospective returns and legal insider activity confirms this simple math. 
David B. Anderson is Sr. Vice President & Chief Investment Officer of Value Equity Financial Counselors, Inc.
P | 816.329.1500
E | DAnderson@FCIAdvisors.com