Robert Shiller has created an index that shows investors’ fear of a stock market crash. Here is what he says now.

By Marc Hubert

The Crash Confidence Index turns bullish as more investors worry about their portfolios.

A large majority of individual investors are worried about a possible US stock market crash – and that’s bullish. This is because collision anxiety is a contrarian indicator. It would be a bad sign if investors were convinced that a crash would not occur. So we can take at least some comfort from the current widespread concern about a possible crash.

We are able to study the relationship between the stock market and crash anxiety through a monthly survey of investors that Yale University finance professor Robert Shiller has conducted since 2001. by the survey: “What do you think the probability of a catastrophic stock market crash in the United States, such as that of October 28, 1929 or October 19, 1987, in the following six months?”

Shiller expresses the results as the percentage of respondents who think this probability is less than 10%. Currently, as you can see in the chart below, 22.8% of individual investors believe this probability is this low. The only other times since 2001 when this percentage fell was during the bear market lows of 2007-2009 and 2011. These are certainly bullish precedents.

(Because this graph can be confusing, care should be taken when viewing it. The graph does not show the percentage of investors who think a crash is likely. Rather, it shows the percentage who think that probability is low So lower values ​​on the chart indicate that crash anxiety is more prevalent, and vice versa.For example, the current reading of 22.8% for individual investors means that 77.2% believe that there is a greater than 10% probability of such a crash.)

You might be wondering if crash anxiety is so high because it’s October, the month of the two worst crashes in US history. But that can’t explain it. The latest reading is lower than all but three Octobers since 2001.

To appreciate the strength of this contrarian indicator, consider the data in the chart below. It contrasts the S&P 500 average total real return following the 10% of months with the highest collision anxiety or the decile with the lowest crash anxiety. The differences are significant at the 95% confidence level that statisticians often use to assess whether a model is genuine.

Crash confidence index readings:    Fear of crash is...  Average S&P 500 total real return over subsequent 12 months  Average S&P 500 total real return over subsequent 2 years (annualized)  Average S&P 500 total real return over subsequent 5 years (annualized) 
Lowest 10% of historical readings   Highest            25.6%                                                        19.5%                                                                   15.3% 
Highest 10% of historical readings  Lowest             5.6%                                                         6.6%                                                                    6.1% 

The real probability of an accident

Shiller’s survey focuses on investors’ subjective perception of the likelihood of a crash. The actual probability is lower. Much lower.

We know this thanks to research conducted by Xavier Gabaix, professor of finance at Harvard University. After analyzing decades of stock market history in the United States and other countries, he and his co-authors derived a formula that predicts the frequency of stock market crashes over long periods of time. The formula has worked remarkably well in the two decades since it was first published.

In an email, Gabaix said his formula estimates that the probability of a 22.6% one-day drop in stock markets is only 0.33% over a six-month period. This percentage was used because this is how much the Dow Jones Industrial Average DJIA lost on October 19, 1987.

Since this percentage is so small, we know that the subjective probabilities reported in Shiller’s survey almost purely reflect investor sentiment rather than objective reality. That’s why contrarians don’t worry about the current high level of accident anxiety and instead think it’s a positive sign.

Mark Hulbert is a regular MarketWatch contributor. His Hulbert Ratings tracks investment newsletters that pay a fixed fee to be audited. He can be contacted at [email protected]

More: Stocks could drop ‘another 20% easily’ and the next drop will be ‘much more painful than the first’, says Jamie Dimon

Also Read: Here’s How You’ll Know the Stock Market Lows Are Finally Here, Says a Legendary Investor Who Called the ’87 Crash

-Marc Hubert

 

(END) Dow Jones Newswire

10-15-22 0830ET

Copyright (c) 2022 Dow Jones & Company, Inc.

Comments are closed.