Trying to figure out investor sentiment to predict future market returns is a form of analysis as old as the markets themselves. Analysis can be both highly accurate and highly inaccurate, depending on the quality and quantity of data used to arrive at a suitable conclusion.
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Bank of America Merrill Lynch’s global equity Risk-Love investor sentiment indicator is one of the more rigorous sentiment indicators around. This indicator tracks positioning, put-call ratios, investor surveys, price technicals and volatility, spreads and correlations measures. The list of inputs is extremely impressive and gives a very comprehensive reading on investor positioning, and therefore, sentiment in the markets.
Some of the inputs included are (a full breakdown can be seen below):
- American Association of Individual Investors – bull less bearish ratio
- National Association of Active Investment Managers Exposure index
- Small retail trader sentiment (Daily sentiment index) for S&P 500
- Major professional brokerage firms and advisors sentiment (Consensus Bullish Sentiment Index)
- Emerging markets economic surprises Index
- University of Michigan Survey of Consumer Confidence Sentiment
- Commodity sentiment (Daily Sentiment index)
- Put / call ratio at market open (ISE Sentiment Index)
- CBOE put/call ratio
- Euro Stoxx 50 put/call ratio
- Nikkei put/call volume ratio
- MSCI Emerging Markets ETF put/call volume ratio
- S&P 500 options put/call skew (delta 25, 3month)
Decoding investor sentiment
Bank of America’s global equity Risk-Love indicator is the most useful when it is at its extremes, at which point the bank’s US equity strategists recommend investors take a contrarian position. When in the neutral position, the analysts believe the indicator gives no edge to an investor.
Unfortunately, the indicator is currently pointing to a neutral reading, giving investors no guidance. However, what is interesting is the fact that the indicators reading has plunged from ‘euphoria’ last month. What’s more, last month’s ‘euphoria’ reading was the most optimistic reading the indicator has given since early 2014. During the latter half of 2015 and early 2016, the global equity risk Love indicator plunged to levels close to readings last seen during the Great Financial Crisis, what Bank of America’s analysts call a great contrarian buy indicator.
Further data from Bank of America shows that traders are finally starting to pare back their short positions on the Dow Jones Industrial Average. Commercial hedges net short positions on the index reached a level not seen since 2010 earlier this year but have since rebounded, although there is still a long way to go before short exposure reaches more normal levels.