Beware Of Unanimous Opinion

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At Wednesday night’s fall seminar, we examined the question of how investors should balance risk and reward.  Among the many topics covered, we noted how polarized bullish and bearish attitudes have become on a variety of assets.

In the period since Federal Reserve Chairman Ben Bernanke indicated the likelihood of additional quantitative easing, investor sentiment has soared for stocks and for precious metals.  Most investors find great comfort being in agreement with the majority of other investors.  Ironically, markets typically provide their poorest returns when investors share extreme bullishness.  Conversely, the strongest rallies usually begin at points of maximum pessimism.  As a result, at least at extremes, sentiment tends to be an excellent contrary indicator of coming market direction.

Since the Fed’s expressed intention of raising the rate of inflation while simultaneously depressing interest rates with direct bond purchases, the dollar has fallen precipitously.  The outlook for the dollar has become so gloomy that a mere 3% of investors expressed bullish expectations in this week’s Daily Sentiment Index (DSI).  To put that in context, as the dollar approached and reached its June peak following a six month 18% rally, 95% to 97% of investors registered bullish expectations.  As the dollar plummeted by 10% over the next two months, bullish readings fell to just 7%.  That was enough to provoke a 4% relief rally prior to the present decline that began in August.

That 7% bullish reading was identical to the DSI level marking the late 2009 low after the dollar had fallen by 16% through most of that year.  Seeing just 7% bullish at the last two meaningful lows and 95% to 97% bullish at the 2010 top should make investors leery of the current miniscule 3% bullish reading.  Investors were extremely optimistic at the top and pessimistic at the recent bottoms.  Today’s level shows even greater pessimism.

DSI readings for the Euro are almost the exact opposite of those seen for the dollar. A better than 20% rally through most of 2009 led to a 93% bullish reading at the top. All of that gain was given back over the next 7 months. The current 17% rally has rekindled an even more optimistic 97% DSI. Can the Euro hold up in the face of such bullishness?

Precious metals have exhibited similar contrary responses to extreme sentiment levels. Silver showed only 12% DSI bulls two years ago at under $8.50. Today at more than $24 everybody loves silver, with a 97% bullish DSI. Gold’s almost 100% rise over that same two years has brought the bulls up to the 98% level.

While stocks haven’t reached the same level of unanimity, they have periodically reached sentiment levels that have signaled danger. Equity mutual funds currently hold just 3.4% in cash, the lowest level in history. Active investment managers surveyed by the National Association of Active Investment Managers have recently raised their equity allocations above the 76% level that has led to negative performance over the past several years. The current Investor Intelligence poll indicates a dangerously wide spread of 22.5 between bulls and bears. Ned Davis Research’s Crowd Sentiment Poll recently reached a bearish extreme optimism level, which has produced negative investment returns for the past decade. Elliott Wave International pointed out this week that 89.4% of the S&P 500’s stocks are trading above their 50 day moving averages. The last six times this percentage has approached 90%, stocks have at least experienced multi-week declines. Approaching 2010’s peak price, however, this reading held in the 90% area for a few weeks before stocks fell 16%. And the widely watched VIX Index now under 20 shows a dangerously high level of complacency.

Extreme optimism does not necessarily sound a death knell for market rallies, but it does accurately identify market tops frequently enough that it should not be ignored. At the very least, these levels of optimism are raising some cautionary red flags. At the other extreme, the excessive pessimism being expressed for the U.S. dollar could well be building a foundation for a meaningful rally. Should the dollar begin to climb, the rallies in stocks, the Euro and precious metals could be shot-circuited, and corrections could soon follow.

Tom Feeney is the chief investment officer for Marathon Asset Management Co, a registered investment advisor with the Securities and Exchange Commission, and for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more by either of the firms, you are invited to email your interest to or call (520) 529-2900 to speak with one of the Portfolio Coordinators.