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Making Sense of Market Sentiment

September 29, 2011

Remember when you were a kid, and your parents warned you not to blindly jump off a cliff just because everyone else was doing it? The grown-up version of that home-spun adage might also include a warning to not blindly dump assets just because every other investor seems to be. But many risk-averse investors seem to be doing just that. Some recent trading days have seen nearly all stocks – even those of healthy companies — being sold. This is unusual, says Portfolio Manager, Ed Perks:

Ed Perks

Ed Perks

“Things like all 500 stocks in the S&P 500 declining on the same day — this is not something we have seen much historically — and that actually happened over the last month. The correlation amongst stocks is rising to near all-time record levels.”

It’s hard to imagine a scenario in which every stock in the S&P 500 is legitimately worth selling. Professional money managers understand that sentiment can often drive markets – and when that sentiment turns negative, investors may not give even healthy assets a fair shake. But this can create opportunities for those willing to take a deep breath and look closer before selling assets. As Perks notes:

“We are very focused on applying our fundamental research – equity and credit research – to identify opportunities, because when you have these mass, correlated movements, there is likely some opportunity to find value within.” 

Market sentiment is such a powerful force that it may even create self-fulfilling prophecies. The European sovereign debt crisis, Perks argues, may even be exacerbated by a vicious cycle involving negative sentiment, as fears of sovereign defaults reverberate into the banking sector. The banking sector then becomes another source of potential trouble and contagion in the unfolding crisis: 

“With the European financial institutions, it seems somewhat circular in that we are caught in this spiral of concern about sovereign defaults and what exposures might be to financial institutions, and then financial institution problems becoming a bigger problem for the sovereigns.” 

This uncertainty in the US and Europe has sent many investors rushing out of stocks and into what they perceive as “low risk” assets –such as US Treasuries. This has led to an increase in the value of Treasuries – despite the recent S&P downgrade ofUS sovereign debt. Although some investors may be scratching their heads at this, Perks thinks it’s related to the continuing uncertainty: 

“I think the initial response to the US Treasury downgrade was somewhat counterintuitive, in that we have actually seen long-term interest rates decline substantially in the US. I think that is reflective of the broader market concerns around the European sovereign debt crisis, the European financial institutions, and more broadly, the uncertainty and challenges that global economies are facing.” 

This uncertainty is having other interesting effects, such as the decline in equities as Treasuries increase in value. Hybrid strategies may be attractive to investors who seek exposure to more than one single asset class. Amidst all this uncertainty, one thing is for certain: In investing, as in life, look before you leap. Your parents warning about jumping off cliffs is probably still good advice.

Until next week, Beyond Bulls & Bears leaves you with a quote from the late Sir John Templeton:

“To buy when others are despondently selling and to sell when others are avidly buying requires the greatest fortitude and pays the greatest ultimate rewards.”

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