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Investor Sentiment – A Poor Measure of Irrational Exuberance

Former Fed Chief Alan Greenspan coined the phrase “Irrational Exuberance” in 1996, during the dot-com craze of the 1990s.  Many interpreted the phrase as his warning that the market was getting overvalued or overheated.

Since the dot-com bubble imploded in 2000, we’ve heard the phrase whenever someone perceives any kind of speculative frenzy in the stocks, housing, commodities or some other asset class or area of the economy.  For many, irrational exuberance means we’re in bubble territory.

When it comes to investing, some commentators talk about the rise and fall of investor sentiment as a precursor to what’s going to happen next in the stock market—usually something bad, like a bubble popping.

Hmmm…does investor sentiment have any predictive value for the stock market?

The graph below plots the S&P 500 against American Association of Individual Investors (AAII) investor sentiment dating back to 1987.  What do we see?

“investor-sentiment-1987-to-august-2015.png"

Well…investor sentiment (black line) swings wildly from bullish to bearish and looks like a Richter scale.  The S&P 500 (red line), in contrast, marches forward to a different tune.

Research finds that positive excitement among investors can generate pricing bubbles and the subsequent investor fear causes the bubbles to burst.  This was evident in hindsight during the dot-com era.  From 1995-2000, investor sentiment was mostly positive (above 0%) and peaked at over 40% just before the crash.

Since then, sentiment has gyrated between positive and negative and has remained well below its Dot-com and 2004 peaks.

Currently, the S&P is reaching new highs, but investor sentiment has been rather muted and tells us nothing about the future rise or fall in the market.

Even the AAII acknowledges, ”outlying sentiment readings don’t always prove to be accurate indicators of changes in market direction.”

While investor sentiment makes for sensational reporting and commentary (e.g., irrational exuberance and the impending stock bubble), it does not offer us empirically-validated proof that it is the indicator we should follow or monitor.

In other words: Don’t pay much attention to investor sentiment data.

It may be possible that we are in or nearing bubbles in social media stocks and biotech stocks, but who really knows?

The only way to know that we’re in a bubble is through hindsight—after the crash.

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