5 Signs Investors Are Dangerously Overconfident Right Now

With the stocks on tear, investors haven't been this excited about the market since the dot-com bubble. Maybe that's why you should be cautious.

As the U.S. finally emerges from COVID lockdowns, the stock market has been soaring, setting two dozen records in 2021 alone. And small investors, flush with stimulus money and fascinated with trading apps like Robinhood, have been throwing billions at the markets, not to mention riskier assets like cryptocurrencies.

The result is that investing seems to be having its biggest pop culture moment in a generation, with celebrities and even teenagers bragging about trading stocks. Elon Musk, chief executive of one of the market's hottest companies (Tesla shares are up 260% in the past year) even hosted "Saturday Night Live."

"I though what we saw in the 1990s was a once-in-a-lifetime event," says Doug Ramsey, chief investment officer of investing firm Leuthold Group. "That assumption turned out to be wrong."

So why the cold water?

Remember, the aim of investing is to buy low and sell high. But stock market always seems most exciting at times, like right now, when prices are already high. It's a big reason professional investors tend to regard rosy market sentiment as a contrarian — that is, bearish — sign.

In addition to the pop culture buzz, a number of popular market indicators that professionals use to gauge investors' bullishness are at all time highs. Others, while not setting records, have reached levels not seen since the giddy months before the dot-com crash.

In other words, while novice investors are cheering, many pros see flashing red lights.

Here's where some of the best-known investor sentiment indicators stand — and what history suggests they mean for stock prices.

Shiller Price-to-Earnings Ratio

Today's Reading: 37

All time record: No, but only late 1990s was higher

One key measure of investors' bullishness is what price they are willing to pay for each dollar in profits a company produces. There are plenty of ways to measure what is known as the market's price-to-earnings ratio. One of the best-regarded and most widely used is the Cyclically Adjust PE (CAPE), otherwise known as the Shiller PE, for Nobel Prize-winning economist Robert Shiller who champions it.

This version compares S&P 500 stock prices to company profits over the past decade, not just a single year. The idea is to offer investors a steady look at earnings, smoothing out one-off events like the out-of-nowhere recession that hit the global economy this past year as a result of COVID-19 lockdowns.

Right now the Shiller PE stands at 37, which means investors are willing to pay $37 for every dollar in annual profits companies earned on average over the past decade. If that doesn't sound like much of a deal, you're right. That level is higher than any time other during the late 1990s Internet Bubble, when it reached nearly 45. For additional context: On the eve of the 1929 stock market crash the Shiller PE reached only about 30. During the depths of the 2008-2009 bear market it fell all the way to 15.

Price to Sales

Today's reading: 2.4

All-time record? Yes

Of course, not all companies can boast about profits. That's true both of struggling firms fighting to stay in business and some of the stock market's highest fliers — fast growing companies that are more concerned about expansion than reporting earnings. As as result, in addition to price-to-earnings ratios, some investors also look at price to sales, a measure of how expensive a stock is for every dollar of revenue a company generates.

As it happens, today's stock market is even more historically expensive when measured against sales than it is when measured against earnings. According to market research firm Yardeni Research, the S&P 500 is currently trading at about 2.4 times last year's sales, and about 2.75 times what market forecasters expect for the coming year. While historical sales data doesn't go back nearly as far as earnings, the current readings are by far the highest on record, with the price-to-sales ratio topping out at only about 2 times during the dot-com bubble.

Individual Investor Sentiment

Today's reading: 46% bullish/26% bearish (average for 2021)

All-time record? No. But recent readings are historically high

Another way to judge how exuberant investors are is simply to ask them. This is something the American Association of Individual Investors has been doing since 1987. Its Sentiment Survey is based on a weekly poll in which members declare themselves 'bullish,' 'bearish' or 'neutral.'

As the AAII itself acknowledges, many market watchers regard its survey as a contrarian indicator with optimism peaking toward the end of bull markets, and pessimism prevailing in the depths of bear markets, often right before stocks being to rise. The share of investors declaring themselves 'bullish' averaged 49% in 2000, the final year of the dot-com bubble. It fell into the low 20s in the summer of 2008, as the global financial crisis unfolded.

So far this year, the average reading has shown about 46% of investors 'bullish,' 28% 'neutral' and 26% 'bearish.' While that doesn't quite match levels of late 1990s and early 2000s, except for a few inconsistent blips, it's warmer than the indicator has run since the early teens.

Margin Debt

Today's reading: $823 billion

All-time record? Yes

Buying stocks with borrowed money is one of the riskiest moves investors can make. If the market goes up, you can earn outsize profits. But if tumbles, you can lose far more than your original investment. This so-called buying "on margin" was one of the things that made the 1929 stock market crash so dramatic, with everyday investors losing not just their savings but getting thrown into bankruptcy.

No surprise then that the amount of margin debt — tracked by FINRA, the brokerage industry's self regulator — tends to rise when greed is in the air, and fall when fear predominates. In March, the volume of margin debt hit $823 billion, its highest level ever, according to FINRA. By contrast, in March 2020, amid the COVID-19 market panic, it was only $479 billion.

Before 2018, margin debt had never climbed above $700 billion. It peaked at about $550 billion (adjusted for inflation), before the 2008-2009 financial crisis, according to market researcher Jill Mislinski.

Put-Call Ratio

Today's reading: 0.49 (4-week moving average)

All-time record? No, but one of its most bullish readings in a decade.

Small investors aren't the only ones who get slap-happy during bull markets. It affects to more sophisticated traders too. One way to measure their sentiment is what's known as the Equity Put Call Ratio. Calculated by the Chicago Board of Options Exchange, it compares the volume of bearish options bets placed on the stock market to the volume of bullish bets, at any given time.

A low number — anything below 0.5 — suggest optimism, while a higher number such as 1, suggests investors are fearful, according to Ramsey,whose Leuthold Group tracks the data. The long-term average over the past two decades is about 0.65. During the past month, however, the ratio has averaged about 0.49. In early December, and again in mid-January the ratio fell as low as 0.38, its lowest level since the summer of 2000.

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