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Briefly Noted

Elevated Investor Pessimism

Our Sentiment Survey caught the attention of many market participants in early July. Bearish sentiment, expectations that stock prices will fall over the next six months, reached 57.1%. This was the 15th highest level of pessimism registered by the survey since it began in 1987.

The State Street Investor Confidence Index also displayed historically high levels of pessimism. The June 2010 reading for the index was 89.7, the fifth-lowest reading since the survey started in 2003.

RBC Capital Markets surveyed 440 capital markets participants in May about their outlook. A majority of respondents thought risk has become higher for every asset class, with stocks and currencies perceived as more risky than sovereign debt. Many also do not expect to issue new debt or equity over the next two years, instead preferring to rely on cash flow and retained earnings to finance projects.

Yields on the 10-year Treasury note fell below 3% last month. Since bond yields and bond prices are inversely related, this also means that 10-year Treasuries are priced at historically high levels. The low yields are perceived as a sign that some investors are preferring return of capital over return on capital.

Clearly, there is a sense of worry among both individual and institutional investors. This is not surprising given the sovereign debt crisis in Europe and the ongoing uncertainty about the U.S. and global economies. Whether these indicators are a sign that fear is at contrarian levels is questionable.

Pessimism in the AAII Sentiment Survey stayed above the historical average throughout much of 2002 and the second half of 2008. (Five of the 10 highest bearish readings were recorded in 2008.) In other words, there have been periods were bearish sentiment has hit seemingly contrarian levels and stayed at them for a significant period of time. Combined with the lackluster performance of the S&P 500 over the last decade, this could explain why sentiment researchers Jordis Hengelbrock, Erik Theissen and Christial Westheide think the survey may have lost its predictive powers during the subperiod of 2001–2008.

Uncertainty about economic growth is also a factor. Though most respondents to the RBC survey thought the global economy would expand over the next 12 months, the overwhelming majority expect the pace of growth to be below the level of 2003–2007. Similarly, the falling Treasury yields reflect expectations that inflation will remain at low levels for the foreseeable future.

None of this tells you what the next 12 to 24 months will look like, only what individual and institutional investors think right now. Therefore, the best investment strategy continues to be diversification, a focus on fundamentals and low valuations. Adjust your portfolio as necessary to keep it in accordance with your risk tolerance, but do not lose sight of your long-term financial goals.

Be sure to take advantage of the Financial Planning section of the new AAII.com. In this section, you can find useful articles in the Personal Finance Library, review the Asset Allocation Models to aid in diversifying your portfolio and gain wisdom from the timeless Lifetime Investment Strategy, which applies now more than ever.

Sources: AAII Investor Update e-mail; “The New ‘Normal,’” by RBC Capital Markets; State Street Investor Confidence Index; and “Market Response to Investor Sentiment” by Jordis Hengelbrock, Erik Theissen and Christian Westheide.

The Baltic Dry Index’s Losing Streak

Just before press time, the Baltic Dry Index BDI ended its streak of falling for 35 consecutive trading days (no, that is not a typo) with a modest rise.

The Baltic Dry Index measures the cost of transporting goods by ship. It is based on charter rates for dry cargo ships. These are vessels that transport items such as iron ore, steel, coal and grains. Excluded from the group are tankers with liquid freight, such as oil.

This index is often viewed as an indicator of the strength or weakness of the global economy. A higher BDI implies more demand for ships, which implies that more raw materials are being transported. Conversely, a lower BDI suggests lesser demand for ships and fewer items being transported. Obviously, if demand for raw materials (e.g., iron ore) is rising, then the global economy should be expanding.

However, the correlation between the BDI and economy is not static. Shipping prices can be influenced by vessel supply, cargo supply, seasonality (e.g., the timing of grain harvests), port congestion and market sentiment. Bill Lines, a spokesperson for The Baltic Exchange, told us that “There are huge volumes of new dry bulk tonnage hitting the market. These are new ships ordered during the boom years.”

None of the shortcomings mean the BDI should be completely ignored. It does shed some light on global demand for commodities. Furthermore, China’s economic growth is estimated to have slowed in the second quarter, which would impact steel and coal stockpiles.

This said, the BDI is not a perfect indicator of economic activity. As a result, the BDI should be viewed in the context of other indicators. For instance, the Association of American Railroads (www.aar.org) publishes a monthly report of rail traffic data. The Chicago Mercantile Exchange (www.cme.com) provides price quotes on commodity futures. Several companies discuss the trends they are seeing in freight volumes, such as FedEx FDX. Plus, various economic reports offer data on how the U.S. and international economies are faring.

—Charles Rotblut, Editor, AAII Journal


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