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Irrationality is in the air

Crosby's index predicts negative returns, based on extreme optimism in the market

Mar 7, 2014 @ 8:51 am

By Daniel Crosby

Markets, quantitative research, bull market
+ Zoom

It would seem irrationality was in the air just as surely as love in February.

The Crosby Irrationality Index was up in February after sitting at just over 71 a month earlier. While the market has made some show of uncertainty and even approached a mini-correction for short periods of time in 2014, levels of sentiment remain elevated relative to what we consider equilibrium value.

A quick look at the history of the index shows that lengthy periods of optimism are common and shouldn't be taken as sell signals necessarily. In fact, “optimism” is the most frequently occurring sentiment we map, which is consistent with the overall positive trajectory of the market over extended periods of time.

The real danger comes when elevated sentiment, such as that we are experiencing currently, meets some sort of event that punctures the collective enthusiasm of the crowd and can send the market hastily downward. While it would be folly to try and guess exactly when and what such a negative event will be, it seems more like a matter of “when” than “if.” What is infinitely more knowable is that the market is at a lofty height from which to fall if something were to occur today. The most recent results and implied returns can be found below.

The five strata of sentiment:

• Revulsion - 0 to 19 CII

• Watchfulness - 20 to 39 CII

• Equilibrium - 40 to 59 CII

• Optimism - 60 to 79 CII

• Mania - 80 to 100 CII

Current CII Score: 78.31 (extreme optimism)

Implied S&P 500 returns (negative returns in parentheses):

• One month - (0.02023)

• One year - (1.686)

• Three year - (4.4235)

The implied returns cited above should be understood less as specific return predictions and more of evidence of head winds or tail winds based on the current level of market sentiment. Given the current, elevated level of market sentiment, it would seem that the stock market has some significant head winds for the short and medium-term future.

The Crosby Irrationality Index is a 0 to 100 gauge of stock market sentiment based on a return weighted mix of fundamental and technical indicators. Scores in the range of 40 to 60 are consistent with what we consider equilibrium, with scores above or below representing bullish or bearish sentiment respectively. Questions or comments about the CII can be directed to Daniel Crosby at Daniel@incblot.org.

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