Physicians' Guide to Wealth

A guide for anyone pursuing financial independence

Q
Identifying Market Bottoms

Jun 1, 2022

Worknik has a good description of a contrarian. They define a contrarian as:

1. Noun: One who takes a contrary view or action, especially an investor who makes decisions that contradict prevailing wisdom, as in buying securities that are unpopular at the time.

2. Adjective: A person who habitually takes a view opposite to that held by the majority.

One indicator that has historically been a key and dependable contrarian indicator is the sentiments of the least experience consumer investor. To determine what the average investor is thinking, one no further needs to look at consumer sentiment reports published by the University of Michigan. The contrarian strategy is to buy when consumer sentiment is negative and sell when they are positive. Extreme readings in either range are typically strong signals to do the opposite.
 
The University of Michigan began doing these surveys in the 1940’s and in 1966 normalized the survey assigning a beginning value of 100 that consumers have rarely reported since. Their survey is created each month by contacting a minimum of 500 households. If consumers were positive about their personal finances and the economy, the index would rise, and more dire forecasts would bring the index down. Since 1966, consumers have mostly had negative forecasts about their situations, and the US economy rarely brings the index back to a reading of 100. The exception is during the Clinton era. From April 1997 to President Bush's inauguration, the index was solidly above 100, and the best run since the report started of people feeling very optimistic about their personal financial future.

This stretch of happy people is easy to understand, as this period consisted of solid economic growth and the stock market hitting new all-time highs almost every other month. New start-up tech companies (aka “Dot Commers”) filed for Initial Public Offerings (IPO’s), and many rallied 100% the same day. From January 1995 to January 2000, the S&P 500 increased 317%, or an annual compounding return of 25.7% per year. Now those were the “good ole days!”.  

Certainly, understandable why consumers were so positive during this period, but seasoned investors, including Warren Buffet, were sounding the warning of a day of reckoning. Alan Greenspan, then-Federal Reserve Chairman, gave a speech on December 5, 1996, that became famous for the use of the phrase he coined describing the stock market as “Irrational Exuberance.” They were right, as the first three years of this century wiped out the previous decade of profits along with the demise of too many to count new startup companies.
 
The point is that when consumers are at extreme levels of sentiment, investors should be aware that the future direction of the stock market and economy will most likely be the opposite of consumer sentiment.  As illustrated in the first chart above, the Consumer Sentiment Index has declined below a reading of 60 only four times since 1966, either as a single-month drop or a multi-month series. In all cases, the extreme bearish consumer sentiment reading preceded a market rally the following 12 months and, on three occasions strong bullish trend.  
 
Below are the dates of these sub-60 readings and the S&P 500 returns for the following 12, 24, and 36 months:
Returns from last month's index reading below 60
 
Last month, the University of Michigan reported that May’s sentiment has dropped below 60 for the second time this year (March and May) and is now the fifth series of readings since 1966. Certainly, makes sense for consumers to be feeling down as gas prices soar with inflation, the Ukraine war, and mortgage rates are not free anymore. However, the contrarian may be seeing this recent drop below 60 for the second time as strong indications the market is nearing a bottom. It would also make sense that the stock market would start to recover as the headwinds discouraging investors will eventually dissipate that will, including price increases slowing, the real estate market assimilating more realistic mortgage rates, and more people accepting some of the more than 11 million job openings.  
 
Also, institutional managers look to the future, not the present, and many US companies continue to produce profits while their stock prices have plummeted, creating attractive buying opportunities.  

What Does This Mean to Me?

We maintain our favorable view of the US stock market and economy. This correction was needed as stock prices have rallied these past three years significantly, and a valuation adjustment would seem appropriate to bring stock prices in line with earnings.
 
Elon Musk made headline catching comments with his Tweet on May 30, stating:
 
“[Recession] actually a good thing,' he tweeted. ‘It has been raining money on fools for too long. Some bankruptcies need to happen.
 
“Also, all the Covid stay-at-home stuff has tricked people into thinking that you don’t actually need to work hard. Rude awakening inbound!”
 
I am not sure that the US is on the brink of a recession with more people working in the history of this country. However, I do agree with Mr. Musk’s comment on “raining money on fools,” as I continue to see companies operating at sub-levels because they can’t find people to work. Maybe the economy doesn’t slide into a recession, but the market correction is beneficial to the sustainability of this market rally.
 
Give us a call if you have any questions or comments about this Brief. Also, please also contact us if you have any questions about your account, as we welcome the opportunity to be of assistance.

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