Friday, September 17, 2010

Hope and Depression in the Investor Sentiment Cycle

Charles Kirk of The Kirk Report has an interesting post up, The Investor Sentiment Cycle, in which analyzes the results of a recent survey he conducted in which he asked a broad group of professional investors to indicate where they believe investors are in the sentiment cycle, a graphic of which is at the bottom of this post.

I am not sure of the exact origin of the Investor Sentiment Cycle, though it was attributed to a graphic from 1998 by Westcore Funds by several sources. My guess is that the chart evolved from a similar graphic from Justin Mamis, which appeared in The Nature of Risk, published in 1991.

Given my recent discussion of the record highs in my proprietary VIX Futures Contango Index, extreme readings in the AAII Investor Sentiment survey (in the newsletter), records highs in the price of gold, record low Treasury yields, surging prices for default insurance for European credit defaults swaps (CDS), etc. it is not surprising that the #2 response to the Kirk survey was that investors are going through a period of depression. On the other hand, the S&P 500 index is now 69% above its March 2009 low, which is part of the reason that the #1 response to the survey was that investor sentiment is currently characterized primarily by hope.

While depression and hope are adjacent in the sentiment cycle, the distinction in an investor’s psyche is an enormous one. With depression, there is a concern that current conditions will likely not improve and that investment opportunities carry more risk than reward. More importantly, the is such an anxiety about the future that investors worry that about the potential for markets to deteriorate to previous low levels and perhaps even get worse than they were in 2008.

Just around the corner from depression is hope, where the outlook is still mostly cloudy with a chance of sun, but there is a widespread belief (perhaps partly wishful thinking, but grounded in some tangible signs of progress) that the bottom is behind us and continued improvements are more likely than not.

Given much of the data I have seen and written about, I believe investors are still operating under the long shadow of 2008 (and beyond), with the result that their psyche is still under the influence of ‘disaster imprinting.’ In terms of the sentiment cycle, this puts them in the depression stage. My personal perspective closer to hope than depression at this point. I understand that hope is a concept that traders should avoid, but I do think that even with all the challenges to the global economy, hope is a more appropriate place to look for investment opportunities.

When the VIX is at 22 and I can sell VIX futures (or options based on those futures) at 32, at least I have the comfort of knowing that I have a large margin of error before I have to worry about some of my trading ideas becoming unprofitable.

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Disclosure(s): neutral position in VIX via options at time of writing

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