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Thursday, July 24, 2003

Confidence and Stock Market Valuation

Justin Lahart checks in at CNN Money with an interesting article comparing the opinions of institutional investors and individual investors on the value of the stock market, noting the pros think the market is cheap right now, as measure by Robert Shiller's survey. Lahart is skeptical of this:

"Shiller's indexes are giving off a similar signal to the readings on sentiment maintained by Merrill Lynch's strategist group. Based on Wall Street strategists' stock and bond allocations, the 'sell side indicator' is not flashing as high levels of bullishness as back in late 2000 (when stocks were a real steal, apparently), but it is still quite high historically. Merrill chief U.S. strategist Rich Bernstein says that, as a contrary indicator, the sell side indicator is the best market-timing barometer he's found. Independent analysis by Santa Clara finance professor Meir Statman has shown it works well.

"So, we know what the pros think, but what about what Wall Streeters affectionately call the 'dumb money'--individual investors? Shiller's been keeping an eye on them as well, and they too are rather bullish. But not quite as bullish as their smart-money peers when it comes to valuations. In fact, they thought the stock market was a better value back in the fall than it is now.

"Maybe they're not so dumb after all."

Before you go out and short the market, note that during the 1990s both the institutional and individual investors lost confidence in the market, so the individuals are hardly right all the time. Still the historical data do appear to show that doing the opposite of institutional sentiment works. Shiller's site notes:

"Confidence in the valuation of the market trended downward for both individual and institutional investors between 1989 and 1999. This downtrend in confidence was reversed after the peak in the stock market in early 2000, and confidence was soon back to levels typical of the 1990s. Since September 11 and the beginnings of the Enron affair, valuation confidence has diverged between individual and institutional investors: individual investors have grown more confident, institutional investors less confident."

Statman's working paper on confidence and stock returns is available here.