The higher a stock soars, the more likely it is to plunge.
An unknown sentiment index says that the U.S. stock market will probably do worse than average over the next 24 months. This includes 25 popular, high-flying U.S. stocks, such as Nvidia.
4.76 percent for NVDA, SMCI for Super Micro Computer, and AVGO for Broadcom.
The market index, called the “U.S. Crash Confidence Index,” was created by Robert Shiller at Yale University 40 years ago and is now taken care of by the Yale School of Management. A group of individual and institutional investors are asked every month, “What do you think the chance is of a terrible stock market crash in the U.S.?” This measure of sentiment, like others, can be used to predict the future: when investors think the chance of a crash is very low, it’s a bad sign.
Note that Yale reports the index as a percentage of those surveyed who believe the chance of a crash is less than 10%. This means that when the reading on the chart is higher, investors believe there is a lower chance of a crash, and when it is lower, they believe there is a higher chance of a crash. A six-month moving average for the institutional-investor index recently hit its highest level in 15 years. It also hit its second-highest level for the individual-investor index.
I looked at the information going all the way back to 2001, which is when Yale started updating the index every month. On average, the monthly readings are not related to the S&P 500’s.
SPX’s total return over the next 24 months was 1.08%. This means that higher index readings are linked to lower-than-average returns and vice versa. If you have 95% confidence in the institutional index, the correlation is significant. If you have 93% confidence in the individual index, the correlation is significant.
Why the Crash Confidence Index is not a reliable sign
The U.S. Crash Confidence Index is a useful contrarian indicator because investors in the stock market become more or less bullish for reasons that have nothing to do with the market itself. Stocks tend to be overvalued when people are irrationally bullish instead of rationally bullish. This is why the market tends to struggle after a lot of people think that a crash is unlikely.
There is a new study by Shiller, Yale professor William Goetzmann, and Dasol Kim of the U.S. Treasury Department’s Office of Financial Research that talks about the role of emotions in the U.S. Crash Confidence Index. The study, which is called “Emotions and Subjective Crash Beliefs,” first got attention in academic circles in June.
The people who answered the survey said that “rare, extreme events” that had nothing to do with the stock market had a big effect on how likely they thought it was that the market would crash. For example, people who had recently been in the vicinity of an earthquake were more likely to believe in a stock market crash than people who had not recently been in the vicinity of an earthquake. For the same reason, if a nearby store sold a winning lottery ticket, the respondent was less likely to think a crash was likely than someone else who did not think that.
Emotions and beliefs
The probability of a stock’s crash increases along with the extent to which trailing two-year return is ahead of the S&P 500.
The contrary indicator based on the Crash Confidence Index doesn’t say that a crash will happen; it just says that returns will be below average for the next two years. The index shows how investors feel and what they think, which is very different from the objective factors that can statistically significantly predict a higher chance of a crash. According to a recent study of these objective factors, the chances of a market-wide crash are lower than usual right now. I talked about this in a recent column.
But there are still some stocks that could crash, which is defined as a 40% drop in the next two years. A recent study found that the difference between a stock’s trailing two-year return and the S&P 500 increases the chance that it will crash. For example, if this margin of outperformance is 100 percentage points, the chance of another crash is very close to 50%. If it’s 150 points or more, it’s almost certain that it will crash.
FactSet data shows that over the last two years, these 25 stocks in the S&P 1500 index have done better than the S&P 500 by more than 200 percentage points. It’s not likely that all of them will crash, but over the next two years, a good number of them will likely lose at least 40%.
