by: Robert Davis, CFA, CAIA

Where is the bottom?  A question that will only be answered after the fact. Not the answer you may have hoped for, but it’s the honest answer.  At Round Table Wealth Management, we are fundamental investors with a focus on earnings, dividends, valuation, and compounding portfolio returns over the long-term.  This perspective doesn’t keep us from considering where the “bottom” is, however, we endeavor to gain perspective on where the market may be developing an outlook that is too dour and how that outlook maybe showing up in data. 

Investor sentiment.  There are no supply chain issues when it comes to receiving negative economic and financial market news.  We view the value of a given stock or equity index as a component of three tenets:  prospective earnings, prospective dividends, and valuation.  The latter of these terms is driven in part by sentiment.  When sentiment runs very bullish on a stock or index, valuations tend to run high, the inverse tends to be true as well.  The following chart illustrates the historical record of the AAII US Investor Sentiment Bullish Readings, which tries to capture the investors’ mood. Survey participants are asked what their respective market outlook is for the next six months.  A high reading indicates most survey participants are bullish and have an optimistic outlook; a low reading indicates decreasing optimism.  We then use these historical data points to analyze the subsequent 12-month total return of the S&P 500 from various dates and sentiment levels. 

We find the above chart interesting as investor sentiment today is at one of the lowest bullish levels on record going back 25 years.  It’s understandable given equity market returns this year and the daily barrage of negative news articles.  In reviewing the historical levels of the AAII index and the subsequent 12-month total returns of the S&P 500, we find that the best average subsequent 12-month total returns occur when sentiment is decidedly negative.  The chart below illustrates that since June 1997, the average bullish sentiment reading is about 39 and the average subsequent 12-month return is 9.8%.  For bullish sentiment index levels below the average, the next 12-month average return is 16.2% and for those levels below that of today (19.4), the average return is 22.6%.  This is not a projection that markets will be decidedly positive over the next 12-months, however, should sentiment improve we would expect equity markets to move higher.

Market breadth provides another interesting perspective on how investors are viewing the market.  The following charts illustrate the percentage of member companies of the S&P 500 and the Nasdaq 100 trading above their respective 200-day average price.  The S&P 500 chart illustrates that the index has not reached a “bottom” compared to prior market downturns, but we should also not expect companies in energy, utilities, materials, or commodity-related industries to sell-off materially in this market.  The second chart illustrates the history of the Nasdaq 100 Index.  The 11% level indicates investors have sold shares and pushed prices down to an extent worse than that at the onset of the Pandemic and in line with the bottoming of the Great Financial Crisis and the DotCom/Tech Crash in the early-2000s.

As shown in the following chart, there appears to be a strong inverse correlation between market breadth index levels and stronger subsequent 12-months returns.

Based on the data shown, historically when the percentage of S&P 500 Index member companies trading above their respective 200-day average is below 25%, the average subsequent 12-month total return has been 26.5%; when the level is 15% or lower, the subsequent 12-month return has been 32.5%.  As of June 22, 2022, the S&P 500 Index level is 17%.

Why are these charts important?

Today, very few investors would be shocked to learn that inflation is high, interest rates are rising, corporate earnings are under pressure and the potential for a recession in the next 18-months is high.  As we stated earlier, we don’t know what S&P 500 Index level represents the market “bottom” and when it will occur, but we do know that all prior market lows were followed by a bull market and new market highs.  Our recommendation therefore is to remain invested, manage risk and keep an eye on sentiment factors as when those factors improve the markets tend to improve rapidly.

Please contact us to discuss this further or any other investment topic.
We welcome your questions, comments and insights.

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