Investor sentiment matters. If this is low, shares are likely to rise in the following months for two reasons. One is that low sentiment means that more bad news is discounted than good, which means that average luck – a mix of good and bad news – should raise prices. The other is simply that we rarely remain depressed or euphoric for very long. Sentiment eventually mean-reverts, and as sentiment improves prices should rise.
This seems obvious. But it poses the question: how do we measure investor sentiment? There are lots of candidates. Weak sentiment could be measured by: a high dividend yield on the All-Share index; low prices of sentiment-sensitive shares such as Alternative Investment Market stocks; retail investors' selling of equity unit trusts; or big discounts (relative to their own histories) on investment trusts.
All these can capture aspects of sentiment. There is, however, another measure: foreign buying of US equities, as reported each month by the US Treasury. The idea here is simple. Investors tend to prefer shares in their own country – ones that are familiar. They only venture into overseas stocks if they are unusually confident. Big foreign buying of US shares thus betokens high sentiment, and selling low.
The facts support this theory. Foreigners were big buyers of US stocks at the peak of the tech bubble in 2000 and again in 2007 when (we now know) investors were overly complacent. Such buying led to big falls in shares around the world. Conversely net selling – such as in 2016 – led to rising prices. Since 1997 there has been a good correlation (of minus 0.46) between foreign buying over a 12-month period and changes in the All-Share index in the following 12 months.
All-Share index and foreign buying of US shares
Foreign buying of US shares therefore seems to be a decent measure of investor sentiment. Sure, it’s not perfect – but then perhaps no single measure can be.
We have, though, another test here: how does this measure predict returns on individual market sectors? If it really is a gauge of investor sentiment we’d expect it to predict returns on sectors that are especially sensitive to changes in sentiment.
And this seems to be the case. There are significant correlations between foreign buying over a 12-month period and annual returns over the next 12 months for several sectors such as IT, construction, general finance and media. Granted, the correlations aren’t huge simply because there are lots of idiosyncratic variations in these sectors. But they are significant enough that stockpickers should pay attention.
| Investor sentiment and sector returns | |
| Correlations between foreign buying of US shares | |
| and sectors returns in the following 12 months | |
| All-Share index | -0.46 |
| Travel & leisure | -0.42 |
| General financials | -0.41 |
| IT | -0.40 |
| Support services | -0.37 |
| Media | -0.37 |
| Construction | -0.32 |
| Based on monthly data since Jan 1997 | |
There is, however, no significant correlation between foreign buying and subsequent returns on several other sectors, such as tobacco, utilities, beverages or food producers. This is what we’d expect. These are defensive sectors that are not sensitive to swings in sentiment and so should not be predicted by sentiment measures.
Which brings me to the punchline. In the last 12 months, foreigners have been record net sellers of US stocks. Friday’s data showed that they dumped a net $195.2bn of them in the 12 months to January.
You might imagine there are several reasons why this might be: a loss of confidence in some FANG stocks; declining current account surpluses in many non-US countries; or a desire to diversify portfolios away from the US. It’s plausible, though, that some of the selling might betoken weak investor sentiment. To the extent that this is the case it points to a strong rise in UK and global share prices this year. And history suggests that sentiment-sensitive sectors such as IT and financials will be big beneficiaries of this.
