Mass crowd psychology in action. That’s one way you could describe the action of the stock market.
Sure, plenty of financial professionals are doing discounted cash-flow analyses and other fundamental calculations on stock prices. So we tend to hear things like, “the price of a stock represents the present value of its expected future cash flows.” That’s all good and well.
But sentiment matters, too. By one definition, market tops are characterized by the point of maximum optimism, and market bottoms are the point of maximum pessimism. Stated differently, when everyone thinks alike, everyone is likely to be wrong.
That’s the concept behind our featured indicator this week. This indicator shows the weekly dollar flows into U.S. equity funds (including ETFs) versus the S&P 500 index. The top clip is the S&P 500 index, and the bottom is the 4-week total of equity funds flows, with dashed lines depicting zones of extreme optimism and pessimism.
Historically, when the amount of money flowing into equity funds from the previous four weeks has surpassed $12.4 billion, stocks (represented by the S&P 500 index) have generally done poorly. However, stock returns have been fantastic when flows have been less than $0.4 billion (or even negative).
This probably seems a bit odd. What’s going on here? Why would more money flowing into the stock market result in lower-than-average returns?
It helps to think of it in terms of liquidity. When people are collectively optimistic about the stock market, everyone becomes fully invested. When everyone is fully invested, liquidity is low—meaning there is no one left to buy. This condition makes it difficult for the market to go any higher.
Ned Davis of Ned Davis Research relates this idea of stock market liquidity to the shock absorbers in your car. If your car has good shocks (ample liquidity), then you can hit a few potholes (random, negative events) and keep on going without a hitch. However, if your car has poor shocks (no liquidity), then you might just crash if you hit a pothole.
This indicator makes more sense when you start to think of high (excessive) optimism in terms of lower liquidity, and vice versa.
So, in sum, we gauge the amount of liquidity in the stock market using equity fund flows as a proxy for sentiment. When the crowd hits an extreme point in sentiment, we take the contrarian position and go against the group. By incorporating these shock absorbers into our analysis, we can better help our clients avoid an investing disaster.
This is intended for informational purposes only and should not be used as the primary basis for an investment decision. Consult an advisor for your personal situation.
Indices mentioned are unmanaged, do not incur fees, and cannot be invested into directly.
Past performance does not guarantee future results.