Think you’re an expert on market sentiment? So does everyone else

As the stock market soars to new highs, you’ll probably have clients point to clues that mean the stock market is seriously overvalued: aged relatives investing in Tesla, for example, or billionaires moving to Thailand.

Rather than throwing a pie in your client’s face, you should probably explain that anecdotal stock market indicators are, at best, a highly suspect methodology for investing. Sure, a dozen people used anecdotal indicators to dodge the technology meltdown of 2000, but at least six of them were liars and the other half were lucky. And, while there’s something to be said for measuring sentiment, it’s an imperfect art — and, for the long-term investor, one that should probably be ignored.

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Sentiment indicators are contrary indicators; that is, they attempt to show when stock fever has reached an unsustainable high. The most famous sentiment indicators are anecdotal, such as the story of Joe Kennedy selling all his stocks before the 1929 stock market crash because a shoeshine boy had offered him a stock tip. After all, if shoeshine boys were in the market, who else was left to buy and push stocks higher?

One problem with that story is that it’s probably not true. Still, there’s no denying that in the short to intermediate term, the stock market is a highly emotional creature, and investor exuberance can coincide with market peaks. Over the years, investors have developed several ways to measure sentiment more empirically than stories about shoeshine boys and house flippers.

One way is through surveys, such as the Investors’ Intelligence survey of market sentiment and another one taken by the American Association of Independent Investors. Both of those, as of the week of April 19th, were at low to normal levels of bullish sentiment — not the levels you’d expect after the type of run we’ve seen since the November elections. (For the record, that’s a bit over 13% on the Standard & Poor’s 500 stock index, including dividends).

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Then there are indicators that track real money, such as options activity and measures of insider sellers. Doug Ramsey, chief investment officer for the Leuthold Group, monitors 30 sentiment indicators and weights them for his sentiment index. So how frothy is it? “In all, it says that confidence has shot up since the election, but hasn’t challenged the highs set in 2014,” Mr. Ramsey said. “For those who believe that cyclical conditions are hospitable, there’s plenty of room to melt up into bubble territory.”

How do today’s sentiment indicators stack up against the nutso 1990s? It’s nowhere close to partying like it’s 1999, Mr. Ramsey said. “It turns out that it’s analogous to August 1997.” You may recall that Alan Greenspan, then chairman of the Federal Reserve, talked about the stock market’s “irrational exuberance” in December 1996. Had you sold in 1996 or 1997, you would have missed three years of market gains — about a 60% rise. In other words, one weakness with sentiment indicators can be extremely long lags between signal and top.

The same is generally true for buy signals. The Investors Intelligence survey, for example, recorded a ratio of bulls to bears of one or less fairly consistently through 2008 — a year which saw consistently horrendous declines.

And, in the down-is-up world of contrary indicators, sentiment has a further problem: Everyone watches it. “Sentiment data points are so widely watched that everyone has become a semi-professional sentimentician,” Mr. Ramsey said. “It’s easy, through a skillful selection of data points, to construct a straw man and declare yourself a contrarian.”

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Mr. Ramsey is not impressed with current bullish sentiment to recommend selling — in fact, his model portfolio is fairly fully invested. “In the big fat middle part of a trend, the crowd can be correct for an extended period of time,” he said.

What do you tell investors who think the market is too frothy? If they have a long time before they will need their money, then you should explain that even after two mammoth bear markets, the S&P 500 has still beaten returns from both bonds and money market funds for the past 20 years. If they’re taking withdrawals or just can’t sleep at night, then it’s your job to adjust their portfolio until their sentiment improves.