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”All economic movements, by their very nature, are motivated by crowd psychology.” - Bernard Baruch
“An error of optimism tends to create a certain measure of psychological interdependence until it leads to a crisis. Then the error of optimism dies and gives birth to an error of pessimism.” - Arthur C. Pigou
“The crowd is right in the trends but wrong at the ends” - Humphrey B. Neill
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Sentiment indicators are used to gauge the over all mood of the market through measuring investors’ general feelings about the state of the market, whether they are bullish or bearish. Historically, some of the best opportunities in the marketplace have been at points where investor sentiment has reached extremes.
These extremes often proved to be exactly the point at which it was time to do just the opposite of everybody else. In other words, if general sentiment is excessively bullish, the smart money go short and if investor sentiment is excessively bearish, the smart money go long.
Note that prices drive the sentiment indicators, not the other way around. Extremes in sentiment is a lagging indicator. They peak or trough well in advance of a market turn. Their value reside in sending a warning that a reversal may be afoot. Also, knowing the right excessive or extreme levels and how to use them in conjunction with other indicators is the key to getting these indicators to work for you instead against you.
There are tens of sentiment indicators that can be categorized based on the data it is driven from like confidence, volatility, market breadth, sentiment surveys, commitments-of-traders data, cash levels, company insiders, Rydex fund flows, as well as many other sources. In this article and future ones, I will focus on the classic, well established, and well used rather than those less known.
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Advisor sentiment polling is conducted* by Investors Intelligence. It measures the weekly sentiment about U.S. stocks among over 100 independent investment newsletters writers and reports the findings as the percentage of advisors that are bullish, those bearish and those that expect a correction.
Note that the bullish and bearish
advisors, when totaled in the chart below, do not add up to 100%. The reason for this is
that a certain percentage of advisors are often in the correction camp.
Therefore, they are not counted as either bullish or bearish - Read more here.
Click to Enlarge chart - Data as of Dec. 18, 09 - released Dec. 23, 09*
Courtesy of DecisionPoint
When the survey was developed, it was originally expected that the best time to be long the market was when most advisors were bullish. This proved to be far from the case – a majority of advisors and commentators were almost always wrong at market turning points. Quite simply, professional advisors are just as susceptible to market emotions as individual investors – they become far too greedy at the top of trends and far too fearful near the bottom.
Investors Intelligence clarified the purpose of its indicator, at the same time giving a good illustration of exactly what investor sentiment is and what it is not. Most notably, like any other indicator, the sentiment index usually tells you nothing - most of the time investor sentiment is ensconced in a normal range, where its neutral reading will provide no useful trading indicator whatsoever. This "normal range" where the indicator doesn't give you an actionable signal, Investors Intelligence considered it to be 45% bulls, 35% bears and 20% correction.
Click to Enlarge chart - Data as of Jan. 1, 10 - released Jan. 6, 09*
Courtesy of Market Harmony
For more stringent levels, a reading between 41% and 54% bulls and Between 21% and 49% bears can be considered a neutral, normal range reading. When less than 20% of advisors are bullish, then this is a positive signal for the market. And finally, if less than 20% of advisors are bearish, then this is seen as a negative signal.
On the other side, extreme readings is where this indicator comes to play a great role. Historically, bulls are 55%-60% when indexes achieve record highs, and those extreme levels of bullishness are negative for the market. Also, bears are 50%-55% when indexes reaches record lows, and those extreme levels of bearishness are positive. Bullish advisors readings above 60% are a rare event and a pre-warning of “irrational exuberance”. Conversely, bearish readings above 55% are a rare event and a strong signal of a capitulation and a bottom at hand.
In
addition to this analysis, traders can analyze the data by examining
the ratio of bullish to bearish advisors. A level of 1.0 means that the percentages of bullish
and bearish advisors are equal, while a level of 2.0 means that
there are twice as many bulls as bears. Generally, peaks of more than
2:1 are a warning of vulnerable markets.
Notice that this indicator doesn't provide a short-term signal but with proper analysis and in combination with other indicators, it can give you an early warning if not an exact market turns. From personal observation and experience, this indicator has superior performance as a stock market bottom finder in comparison to find market tops.
Click to Enlarge chart - Data as of Dec. 18, 09 - released Dec. 23, 09*
Courtesy of DecisionPoint
According to the survey release on Dec. 29, 09 following the biggest rally in the S&P500 in 70 years, pessimism fell to the lowest level since April 1987, six months before the Black Monday equity market crash.
The proportion of bearish publications fell to 15.6% in the last week of 2009 from 16.7% a week earlier (first chart above). Bullish sentiment were down very slightly to 51.1% from 52.2%. Accordingly, the ratio between bulls and bears increased to 3.27% from previous high 3.13%. Those expecting correction are 33.3%. It is worth nothing that sentiment has improved sharply since October 2008, when the financial crisis drove the survey's figure to a 14-year high of 54.4% bears.
Notice that though the bears moved deeper into hibernation according to this release with their lowest reading since April 1987, that same year
back more than 22 years ago saw five more months of gains before black Monday crash, with the DJ Industrials moving from 2,335 in April to a high of 2,709 in late August.
Latest survey published on Wednesday January 6, 2010 for the previous Friday's cutoff January 1, 2010* showed the proportion of bearish publications fell to 16.9%. Bullish sentiment were down to 48.30%. Accordingly, the ratio between bulls and bears decreased to 2.86%. Those expecting correction are 34.8%.
Though the number of bullish advisors is still 48.3% and not yet at the irrational exuberance 60% reading scored in early and late 2007 when the market made all-time high (Second chart above), given the market's current vulnerability, that number is still very high.
The bearish advisors total is at 16.9%. This is so extreme as I explained above. Comparing to readings over the last several decades, we can't find such low readings. Even at the peak of the bubble years in 2000 the number of bears was generally greater than 30%!
Observe the bullish to bearish advisor ratio of 2.86% (3.27% two weeks ago). The last time the ratio was that high, it coincided with a pullback if not all time high. Spikes of this kind are associated with extremes in bullish sentiment and in the past have at times preceded an important market top. This is very elevated level that should warrant attention.
Also, keep in mind that the latest reading represents what investors felt in the last week of 2009 where the market pulled back sharply in the last hour of trading day. Today, we have 35 points gains in the SPX500 from that day low close of 1115. Chances this bullish move will work its way in the next two weeks releases to show higher bulls, lower bears or both.
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Click to Enlarge chart
*Courtesy of the Elliott Wave international
Chart above is another way to analyze the survey's data by dividing the percentage of bulls by the percentage of (bulls + bears), omitting those who expect a correction. By doing so, we get a measure that shows just how fully committed advisors are to the bull or bear side. The latest total of 75% is the highest since the Dow’s October 2007 all-time high, which was 76%. So, by this measure, both bullish and bearish extremes are completely consistent with a market high.
Click to Enlarge chart - Data as of Jan. 1, 10 - released Jan. 6, 09*
Courtesy of Market Harmony
Chart above is yet another way to analyze the survey's data by subtracting the percentage of bulls by the percentage of bears and omitting those who expect a correction to get Bull/Bear spread. The latest spread is high 31.4% is near or at the same levels when the SPX500 made its October 2007 all-time high. The B/B spread of the previous week was high 35.5%. So, by this measure, both bullish and bearish extremes are also signaling market high.
Until next article - be happy, do good, and the rest will be taken care of!
GoodVibe
Mr. Lucky
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*Cutoff for the poll is Friday, and the results are released to the media the following Wednesday. Charts are aligned to reflect the effective date of the poll cutoff, not the release date.*Visit DecisionPoint, Market Harmony, and EWI for the latest data as well as wealth of information. This is not endorsement and I am not affiliated with any of them.
As usual you are making much too much sense to be argued with. And I am checking my portfolio to be certain that I am ready for the ride to come.
Posted by: Mary | January 13, 2010 at 07:49 AM