The dangers of unchecked optimism

Roughly two weeks ago we introduced you to the Crosby Irrationality Index, a 0 to 100 gauge of market sentiment constructed from a weighted mix of fundamental and technical indicators.
At last report, we appraised the market to be “highly-optimistic-but-not-quite-downright-manic” and the latest CII sends a similar message. There is a growing chorus of those who think the market is overvalued (I’m a member of said choir) right now that is doing its best to warn people about the dangers of unchecked optimism.

However, these fun-haters are coming head to head with the reality of crowd psychology, which is that many people are just beginning to feel safe again now — after the enormous gains of 2013 have been realized, a run-up in which they likely had no part. It is against this fractured backdrop that I present the latest CII results:

The five strata of sentiment:
• Revulsion – 0 to 19
• Watchfulness – 20 to 39
• Equilibrium – 40 to 59
• Optimism – 60 to 79
• Mania – 80 to 100

Current CII Score: 71.5 (Optimism)
Implied S&P 500 returns:
• One month 0.0221
• One year -2.4733
• Three year -6.489

The CII implied returns cited above should be understood less as specific return predictions and more as broad evidence of the financial head winds we currently face. After all, these numbers are based on historical precedent and we know that history repeats itself until it doesn’t. We may not yet be in the throes of market mania, but it’s hard to argue that there are many bargains to be had at this point, especially for investors purchasing products that mirror equity benchmarks. At times such as these, it behooves financial advisers to begin to manage the expectations of investors, revisit the fundamental tenets of investment decision-making and encourage prudence.

Your returns made you a hero in 2013, but it’s my bet that your skills as a therapist are what will make them love you in 2014.

Dr. Daniel Crosby is a behavioral finance expert who works with organizations to develop products and messaging to maximize positive investment outcomes. Among his current collaborations is “Personal Benchmark”, a system of embedded behavioral finance delivered by Brinker Capital.