Sentiment affects valuations:  Last year’s big rise in the S&P 500 was sparked more by optimism and rising sentiment (which resulted in higher P/Es) than earnings growth.  Can we get another strong year of stock market performance based on rising sentiment?  Let’s first take a look at current sentiment:

  • AAII Investor Sentiment Survey:  Bulls grew a whopping 8.8% last week and stand at 41.8% compared to a historical average of 38%.  The number of bears is below average.
  • Investor’s Intelligence:  The percentage of bulls is very high and bears very low indicating widespread optimism.
  • CNN Fear and Greed Index:  Very greedy – six of seven components are at greedy or very greedy levels.
  • Option ActivityAccording to SentimenTrader, the ratio of bullish/bearish options was at the highest since March of 2000 – coinciding with the tech bubble peak.

Conclusion:  It’s no surprise that stock prices soared along with sentiment last year and into this month.  Sentiment is very elevated now with limited room for further improvement.  Further advances in stock prices will have to come from a strong economy and solid earnings growth, not sentiment, in our opinion.  We don’t expect the P/E on the S&P 500 to rise any further.


On a recent conference call, the market strategist at Schwab, Liz Ann Sonders, reviewed 13 different measures of stock market valuation.  She joked there was something for everyone – regardless of your market view, there’s a valuation measure to support it.  We think it’s important to look at more than one valuation measure because valuation metrics are based on different economic variables and formulas.  Here are the ones we think are the most revealing and helpful:
Equity Risk Premium – measures the spread between the equity yield (inverse of P/E) and the 10-year Treasury yield.  Analysis – inexpensive (this indicates stocks are cheap relative to bonds).
Rule of 20 – the inflation rate plus the forward P/E on the S&P 500 should be less than 20 (currently 20.7).  Analysis – fairly valued.
S&P 500 forward P/E – based on forecast earnings – now 18.6x.  Analysis – expensive based on historical P/Es.
Total Market Cap/GDP – measures the total value of stocks to the size of the economy (Warren Buffet’s favorite gauge).  Analysis – very expensive.
The analyses run the gamut from inexpensive to very expensive.  Valuation metrics are not a market-timing tool (for those investors so inclined) but rather a weighing machine.  It gives investors a framework for just how expensive the market is and where we may be in a market cycle.  Valuation metrics have more predictive value for individual stocks.  After all, they are usually the basis for concluding a stock is undervalued or overvalued.
Even though most market valuation measures are flashing yellow or red doesn’t mean the stock market can’t go higher.  But eventually valuations will matter and could be a market headwind.  Our expectation is that solid corporate earnings growth in 2020 will take some of the pressure off currently stretched valuations.

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