Investors have a tendency to pay too much when things are going well, and sell for too little when the market struggles, so it’s useful to have an idea of how much sentiment is currently built into stock prices. That’s why Citi has been using its Panic/Euphoria index since 2002 to measure sentiment using an array of sometimes contradictory factors. The current level of euphoria implies an 80% chance of a market downturn in the next year, small caps have the highest valuations relative to large caps in 35 years, and Federal Reserve Chair Janet Yellen’s comment that rates might increase six months sooner than expected sent barely a tremor through the markets.

“It is in this context that a review of the Panic/Euphoria Model, our primary and proprietary sentiment metric, seems worthwhile,” writes Citi analyst Tobias Levkovich in a March 21 report.

Russell PE Index less SP500 0314

Breaking down the Other PE model

The model uses premiums paid for puts and calls, short interest, retail money market funds, margin debt, the average bullishness of the American Association of Individual Investors (AAII) and Investors Intelligence, gas prices, trade volumes, commodity prices, and put call ratios to arrive at an estimate for sentiment. The factors are equal-weight, but they are also averaged and detrended in ways that make the model proprietary.

The model was also recently adjusted to exclude the effects of the dot com bubble, and Levkovich says that the updated version would have provided more useful euphoria signals ahead of previous market tops, showing the general robustness of the model.

panic euphoria revisited 0314

panic euphoria revisited since 2004 0314

Sentiment isn’t the whole story

Levkovich isn’t revisiting the structure of the PE model to scare investors off. He is generally bullish over the next year, but reiterate the need for tactical caution as the probability of a short-term correction grow.

“Investors could become quite nervous about elevated sentiment indicators but we would remind them to consider the other factors that influence markets,” writes Levkovich. “Valuation is modestly positive using a variety of measures including a normalized earnings yield gap as well as price-to-book and P/E Bull’s-Eye methodologies.”

He also points to supportive credit conditions and higher capex intentions as signs that the market will continue to grow. Levkovich forecasts EPS growth of about 7%, and notes that buy side analysts have been predicting growth around 8%. But to realize those returns, investors should do their best not to get caught if the market drops. More importantly, the will have to avoid the trap of selling at the bottom of the trough only to rebuy when prices rebound.