As the stock market crash continues, it’s a sobering reminder that stock markets are basically just measures of investor sentiment. They reflect the future expectations of investors. That is, their expectations of economic performance and more specifically of individual businesses.
Share prices rise when investor sentiment improves and fall when it deteriorates. When share prices swing abruptly, it’s an indicator that sentiment has changed very sharply. Likewise, when share prices are only moving one way (as in a stock market crash), it shows that sentiment is firm and that investors have strong convictions.
Clearly, investor sentiment is currently very poor. In fact, it’s about as bad as I’ve ever seen it. It certainly seems a lot worse than it was during the depths of the financial crisis. Even more worrying is the fact that we don’t know how much worse things are going to get.
Bulls and bears
Investor sentiment alternates between being bullish and bearish, mostly operating between the two. Sir John Templeton – one of the most successful investors – famously said that ‘’bull markets are born on pessimism, grow on scepticism, and die on euphoria’’.
It follows, that it’s better to invest in periods when sentiment is poor, than it is in more bullish times from a long-term performance point of view. This is mainly due to valuations.
Worsening expectations result in lower share prices and lower valuations (how much investors have to pay to own a share of a company’s profits). This is significant because valuation is the biggest indicator of future long-term performance.
From this, we can also understand that the very best time to buy is when sentiment is at its very worst. In fact, the best time to buy is when the prevailing opinion is that things can’t get any worse, that economies and businesses are set to be destroyed.
Where is the bottom?
When sentiment is at its worst, the only way for stock prices is up. This point represents the bottom of a stock market crash. After this point, either future expectations improve, or valuations become attractive, bringing investors back into the market.
Of course, it’s impossible to time the market perfectly and buy at the very bottom of a stock market crash. What’s more, at times like these, it also seems impossible to predict which way sentiment is going to move next.
But what we can do, is acknowledge that stock markets are unusually cheap, and that sentiment is atrocious. From this we can then determine that any return to anything approaching normality will likely lead to positive investment returns. This is especially the case when competing investments, such as bonds and savings, offer such poor rates of return.
However, given that both stock markets and expectations are on a sharp downward trajectory, there’s clearly a degree of risk in investing now. This is why, instead of investing one lump sum right now, I plan to slowly drip-feed it into the market, over a period of weeks or even months. This approach might not offer the best returns, but it will surely help me to sleep better at night.
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Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.