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Why High Investor Sentiment is a Bad Thing

I was once told to that the individual investor does the wrong thing at the wrong time. I don't necessarily follow contrary investing but I always check investor sentiment before making a deal.

Specialists Peter Kennedy and Michael Gagliano, foreground left and right, work at their posts on the floor of the New York Stock Exchange, Thursday, Oct. 10, 2013. Stocks are rising sharply in early trading on Wall Street following hopeful signs that a budget impasse in Washington may break soon. (Credit: AP)

When I first got in the business, I remember an older financial advisor saying to always remember the individual investor does the wrong thing at the wrong time.

I don't necessarily follow contrary investing but this statement has always been in the back of my mind. I have always thought about this and took a snapshot of where investor confidence is when making investment decisions.

With that in mind, there is a lot of data that supports that the investor sentiment index is one of the most useful pieces of information in the market place. Not to be confused with consumer confidence, which I tend to find useless, investor sentiment really has been supported with data for 40 years.

Simply put, when investors feel good about the market and aren’t afraid of adding money to their portfolios, they are usually met with disappointing returns over the following 12 months. Measuring investor sentiment since 1970, the bull and bear report shows that when sentiment is between 80 and 95 percent, the returns on the stock market 12 months later are negative. In fact, when investor sentiment has been measured above 90 percent, the stock market returns on average were down 10 percent 12 months later.

Specialists Peter Kennedy and Michael Gagliano, foreground left and right, work at their posts on the floor of the New York Stock Exchange, Thursday, Oct. 10, 2013. Stocks are rising sharply in early trading on Wall Street following hopeful signs that a budget impasse in Washington may break soon. Credit: AP Specialists Peter Kennedy and Michael Gagliano, foreground left and right, work at their posts on the floor of the New York Stock Exchange, Thursday, Oct. 10, 2013.  Credit: AP

Conversely, when individual investors sentiment is very low, times when as we say in the business, "you can give stocks away," is usually the time you want to invest.

The data shows that when investor sentiment is low, 20 to 50 percent, the returns on the stock market 12 months later has averaged about 15 percent.

All of this supports what my friend advised me many years ago about the individual investor truly being a novice.

Over the last few months, investor sentiment has been very high, hanging around 80 percent confident. When you combine this statistic along with lowering earning forecasts and a slow world economy, all investors need to start reducing their equity exposure. There are many reasons for stocks to go lower from here and very few reasons for stocks to go a lot higher. I don’t believe you will be paid to be an equity investor over the next 12 months.

Be careful.

TheBlaze contributor channel supports an open discourse on a range of views. The opinions expressed in this channel are solely those of each individual author.

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