Overconfidence by Investors Could be a Harbinger of Things to Come

stock exchange

Market optimism is at an all-time high based on investor sentiment. The markets have entered the new year at record highs, while the current bull market is now the second longest in U.S. history. Yet no one seems to be uncertain about where its headed. There’s no evidence of hedging in the markets or bearish sentiment anywhere.

A survey by Investors Intelligence revealed that 64.4 percent of investors expect the market to keep moving higher, while just 13.5 percent expressed more bearish thoughts. But some analysts view this overconfidence as a dark omen. The last time the spread between bulls and bears was so wide was right before a stock market crash in 1986. In other words, it could be the calm before the storm.

The only thing we have to fear is a lack of fear altogether

One way investors can get a sense of risk and uncertainty in the markets is to look at the CBOE Volatility Index, affectionately referred to as the VIX. Typically, a level of 20 or more means elevated risk in the markets, while anything under 15 means investors aren’t all that concerned about risk. Right now the VIX is just over 10. Moreover it hasn’t even breached the 15 mark more than a couple of times in the past year. On the surface it would seem as if investors think there isn’t a risk in the world that could derail this market.

But despite what it looks like, there are warning signs that the market is becoming overextended. The first thing we can take a look at is how much stocks are overvalued right now. The average median P/E for the S&P 500 is 14.68 – as of today, it stands at 26.78. What’s more is that, as interest rates climb, earnings should fall as companies spend more on loans and other financing expenses, making valuations even more unrealistic to maintain.

It’s hard to see problems when optimism is so high. It seems as if good news is priced into the markets, while bad news has gone largely unnoticed. With the current environment of rising interest rates, investors would be wise to exercise caution going into the new year. Only time will tell if the optimism continues throughout the rest of the year.

One thing investors need to keep in mind, though, is that the markets could easily keep rising throughout 2018, even as P/E ratios climb and earnings fall. Oftentimes, the fundamentals take a back seat to trading activity. If enough investors are bullish and buying stocks, then regardless of intrinsic values, stocks will rise. Historically, markets have continued to flourish even with extremely high P/E ratios. But as with all things, eventually balance must be reached.