Asymmetric Investment Returns - Insights into portfolio management beliefs, strategies, and tactics that aim to create a positive imbalance between risk and reward

Crowd sentiment has become very optimistic according to the AAII Investor Sentiment Survey. The poll shows the investors who are "Bullish" thinking the stock market will rise has exceeded its long term average. Bullish sentiment tends to follow, and at times precede, price trend changes as investors eventually overreact. After prices have trended up, investors as a crowd tend to become more and more optimistic that prices will continue to rise. As prices go down, investors tend to extrapolate that action into the future. Prices, therefore, drift in one direction or another based on under-reaction this way. But then, at some point prices sometimes get to a point of overreaction as demand to buy more has peaked. After everyone has already entered, who is left to bid up prices? Of course, a strong trend can continue far longer than you expect, but these polls are useful to understand so that we aren't caught off guard when a trend change does begin. Strong upward trends decline after people become overconfident and complacent. 

Source: http://www.aaii.com/sentimentsurvey

There are many paradoxes in investment management as well as other things in life. I’m always noticing them, drawing distinctions, and comparing and quantifying them.

I find that many things initially seem to be in conflict. On the one hand, we need to quantify things to determine probability and to make good decisions. On the other hand, there are many issues with quantifying and discovering the real probability. Those who do it best are well aware of the paradoxes. As with anything, doing something doesn't necessarily mean you do it well. Once we figure out what to do, we have to do it well. 

On this Super Bowl Sunday, all the math and science is present, though even those who quote it the most seem unaware of how it works. Ah, there is another paradox. For everyone I know who doesn't have any real understanding of probability and statistics at all I probably know another whose mind is full of so much math they are unable to apply it in the real world. I learned my most useful math on my own and I think that’s been an advantage. First, I did it because I wanted to, not because I needed a grade. Then, I really needed to know it to apply it in my portfolio management systems, not just to score on a test. That may be a disadvantage for those who learned even at the most Ivy of leagues. Intentions can make all the difference. 

The paradox today is about how college football ranking leads to a Super Bowl, or not.

Earlier this week I pointed out how the National Signing Day for college football gets a lot of press based on the rating agencies. The school who happens to attract the most top ranked recruits will get the most media attention for having the top ranked class. Yet, the ranking is based on what another organization believes the rating should be. It has nothing to do with a individual programs own proprietary rating of how they believe that player may fit within their program. The paradox is; on the one hand, the rating agencies quantify the talent and skill and that's at least the right intent, on the other hand their methods may not actually be accurate or useful. Or, it may simply not be useful to an individual football program. 

Waiting around for the Super Bowl today, I thought I’d check to see how football programs ended up on Rivals.com recruiting class ranking. Steve Megargee, a Staff Writer at Rivales.com wrote a excellent story titled "Super Bowl rosters filled with underdog stories". (I just noticed that he is up the road in Brentwood, Tennessee). In it, he said:

Half the Patriots who came up during the Rivals.com era weren't five-star, four-star or even three-star prospects. Eleven of those 36 players signed with FBS programs as two-star recruits. The remaining seven either began their college careers as walk-ons or enrolled at non-FBS programs. 

Now they're heading to the Super Bowl.

So even though the Patriots enter this game as slight favorites, they actually are the Super Bowl team with the most underdog stories.

Judgemental heuristics are a "rule of thumb". People naturally want to make quick decisions and judgements, so they draw from what they know. If we know enough of the right things, we can have 'expert intuition' and our 'rules of thumb' may be useful, at least initially. 

I enjoyed the article because it pointed out that many of the players on the field in tonight's game weren't ranked as top recruits in the early stages of their career. Still, you may consider that the title of the article still called them "underdogs". You can probably see how judgemental heuristics can stick with us that way. Would we consider them an "underdog" just because some rating agency hadn't ranked them high so many years ago?

There are no underdogs in tonight's game. That's why they all get a ring.

His tweet was right on:

Patriots get five-star results from players who were two-star recruits (or less).

I just finished reading tomorrow’s newspaper. Do you want to know the score of the game?

Maybe watching it all play out as the game unfolds is what makes the game enjoyable. 

Many people are unable to enjoy not knowing the outcomes, so they sit around trying to figure out what’s going to happen next.  

If they knew what would happen in advance it may not be worth watching- the mystery is removed.  Maybe that's why the most watched games are those expected to be very close match-ups. 

When they believe they have figured out what’s going to happen next, their expectations are set. Expectations create a hope, desire, and attachment for something to turn out as they believe.

The match-ups that are expected to be heavily skewed to one teams favor doesn't seem as exciting.

That is, unless it ends up being an outlier: the unexpected happens. 

I'm on my way to watch the Tennesee Volunteers football team play Cincinnati in some fancy club seats at Neyland Stadium. I have no idea who's going to win the game. And becuase of that, I am certain we are going to enjoy watching it all play out.

When people feel uncertain about the future, they gather information trying to be more sure. But rather than looking at information that contradicts what they already believe, they instead focus on information that confirms what they believe. It’s called confirmation bias.

Confirmation bias is a cognitive bias whereby one tends to notice and look for information that confirms one's existing beliefs, whilst ignoring anything that contradicts those beliefs. It is a type of selective thinking.

People are always uncertain about the future- we just don’t know outcomes that haven’t yet occurred. The outcome is random- it’s unknown in advance. We don’t know in advance which position will be a winner or loser, or how much it will win or lose. But, we don't need to.

So, uncertainty may be kind of an illusion. They probably feel more or less uncertain depending on the recent past. When a price trend has been drifting up and the daily range is tight, they probably feel more sure about it. But when the daily range suddenly expands (volatility increases) as prices go up and down a little more, they may become more uncertain. That’s when they start trying to figure out what’s going to happen next. But all they seem to really do is look for information that already confirms their position.

Eventually, they under-react or over-react to new information. And that’s what makes a trend…

Someone mentioned a mutual fund company pointed out that three of the five largest mutual funds are money markets and the largest is a bond fund. That’s not an unusual comment from a mutual fund company .  Most mutual funds have a relative return objective so they primarily stay fully invested and they want their investors to stay in their funds, so they are good at finding reasons to be optimistic about the market. Because the relative return funds don’t reduce their exposure to risk, they track the market and that includes on the downside. If investors in mutual funds want to reduce their risk, they have to take it upon themselves to sell the funds and invest in a money market. Of course, there is plenty of evidence that the overwhelming majority of investors aren’t very good at making such tactical decisions successfully. Most investors do the wrong thing at the wrong time, but that isn’t to say no one can do it. Some academics call it “market timing” and say you can’t do it. Of course, they approach their studies by framing them the wrong way and they require absolute perfection to prove success. They don't seem to appreciate the value of controlling exposure to loss in falling markets, which is called active risk management.

Money market funds are considered very low risk with an objective to maintain a fixed $1 value and pay income. Money market funds are very liquid, and hold very short term debt like commercial paper and Treasury bills. Money markets are essentially a “cash” position. In times of high uncertainty, investors tend to park their money in a money market. When other markets are perceived as a better bet, investors shift from money market funds to those markets, like stocks.

Our quantitative studies find that when money market assets are relatively high there is liquidity available for buying stocks. When money market assets are low relative to the value of the stock market, the liquidity available to buy stocks is low and the risk is higher for stocks. Therefore, in this case what seems logical is: there is an inverse correlation between money market assets and the potential for the stock market. When money market assets are relatively high, the liquidity is available for buying stocks. A high level of money market assets is a contrary indicator.

Sure enough, according to Market Watch the top 5 largest mutual funds ranked by assets are:

1. Pimco Total Return
2. Fidelity Cash Reserves
3. Spiders S&P 500 ETF
4. Vanguard Prime Money Market
5. JP Morgan Prime Money Market

The mutual fund company was trying to make a point that four of the top five largest funds right now are non-stock funds and that may provide buying power for stocks.  However, the actual value of funds at a specific time isn’t so meaningful, but the relative change over a period may be more meaningful. We created a chart called Money Market Mutual Fund Assets that shows the trend in money market fund assets is actually down. Based on data as reported weekly by the Investment Company Institute, there is less money in money market funds than at the last stock market peak. This seems to agree with the high optimism recorded the last few months by investor sentiment polls. You can probably notice the inverse correlation betwen money market assets and stock prices. The stock market as measured by the S&P 500 index declined more than -50% from late 2007 to the low in March 2009. During that time, there was a spike in total assets in money market funds. Since stocks have been rising, money market assets have been declining. In fact, for the last several months that value has actually been less than it was at the last high point for stocks. If anything, this seems to suggest there is less liquidity available that can be used to buy stocks. Therefore, the potential demand may be lower, not higher, at this point. 

Data Source: Investment Company Institute

Someone on a private message board for investment professionals posted a link to an article that included statements like: “Our Rules-Based Investing process has always been 100% strategic and completely eliminates human emotion from the decision-making process, hence the Rules-Based name.”. 

My first thought is that is appears this investment manager may actually be using a “strategic asset allocation”, which typically means he is passively asset allocating and maybe re-balancing once a year. That strategy, if you can call it one, only works in hindsight when they’re able to use perfect hindsight to select the best performing allocation mix and funds. Strategic asset allocators got caught in a devastating loss trap during the 2008-2009 waterfall when diversification didn’t avoid the losses when all assets plummeted. I say that with confidence because I know there was no asset allocation that didn’t participate in the bear market because stocks, bonds, commodities around the world declined together. To be sure, just ask a strategic asset allocator for a composite of their actual performance of the accounts they manage. Be sure it includes a line chart of the actual portfolio value over time and a measure of the actual draw-down ; the amount it declined from a high point to a low point. But I don’t think this is the main issue with the quote I pointed out.

A rules-based process doesn’t “completely eliminate human emotion from the decision-making process”. 

Emotions are feelings like fear, greed, optimism, etc. 

Not even a fully automated set of rules eliminates the fear of loss, or missing out, or the euphoria when it’s going real well. 

For example, we could say the S&P 500 stock index is a rules-based process based on S&P’s rules for selection, rejection, and cap weighting. No matter how much a person may believe in it; 

-They were probably scared when half their capital was gone, the government was handing out taxpayer’s money to banks/brokers so they could continue operations, and the talk was Great Depression with no end in sight. 
-It’s still at the same value it was several years ago. I guess some holders at some point feel they have missed out- they’d have been better off in a money market in hindsight. 
-Yet, if they held through the waterfall and stayed in as it recovered they probably get greedy and excited about the gains. 

Rules and systems, no matter how automated, do not necessarily eliminate emotion. In fact, emotions may be built in to a system. If you tend to be more greedy and less concerned about loss, your rules will be geared toward going for the upside with less regard to the downside. The likely outcome is best expressed with the old saying;  “Bulls make money, bears make money… pigs get slaughtered”. Emotions are experienced during the process at one point or another. If a person is looking to impair their feelings, they will eventually be disappointed. 

Executing rules just brings out a different set of emotions. I often see evidence of that on some of the private message boards of research groups I’m involved with from people who are trying to operate models or systems, but second guess them. That is especially true if they didn’t develop the system or model themselves, or they didn’t study it enough that they know how it acts. I will suggest that more people may actually have more emotional reactions trying to follow rules than they do acting on their feelings. That is especially true if their ego is overwhelming or they suffer from overconfidence. Of course, acting on your feelings is very costly for most people - that probably includes you. 

Finally, I wouldn’t put too much emphasis on whether something is rules-based, automated, etc. Automation and rules alone doesn't lead to good outcomes. I know of plenty of rules-based programs that are still clawing their way from the bottom of the lake. The author who penned the comments about rules-based investing seems to have the objective of a "rules-based" method, which says nothing about an intentional outcome. 

Of course, I comment about this because I operate a very systematic process that is necessarily rules-based. Our systems for decision-making are quantified which means we know the probability and mathematical expectation for the signals for entry, exit, and risk control. That necessarily required rules for buying and selling and controlling risk to be verified though a quantitative testing process as a complete system.  It also requires experience executing it in the real world. Many portfolio managers are probably making their trading decisions with no real understanding of the probability or expectancy of their method. For me, it’s necessary to have a logical reasoning behind how we make entry and exit decisions. We have a quantifiable mathematical basis behind our belief that a system for buying and selling has a strong probability for creating a positively skewed asymmetric return profile.  You may notice that’s an objective based on a desired outcome, not the strategy. 

We posted a new article in the Resource Center called Using Investor Sentiment as a Contrarian Indicator.

Investor Sentiment as a Contrarian Indicator was first written by Wayne A. Thorp in 2004. Some of the numbers have changed since then, but it's still a useful explaination about how investor sentiment is used as a contrarian indicator. The emphasis on paying attention to extreme readings in sentiment continues to hold true. For example, bearish sentiment reached a record high of 70.3% on March 5, 2009, just as the bear market was reaching a bottom. Investors as a crowd become fearful as prices fall and they become more optimistic as prices rise - just the opposite of rational behavior. This is especially true for investors who are passive in their tactics and "buy and hold". Passive investors tend to grossly underestimate risk and overstay their positions until their losses are much larger than they expected, larger than they can tolerate, or losses are larger than they can afford. Investor sentiment reaches an extreme level at major turning points. To read the full article, click HERE.

Someone commented that I've been "right on the money" with my remarks about investor sentiment at turning points this year. It wasn't me that was right. My intention isn't to play a game of right or wrong, but instead to have a clear view of that the market is telling me. When investor sentiment as measured by polls like the AAII Individual Investor Sentiment Survey is overly pessimistic after prices have already fallen, those who want to sell have already sold. That is, prices had already declined and then afterwards the investors state they are bearish (believing prices will fall) in the sentiment poll. It's an example of how people extrapolate the recent past linearly into the future. After prices have already declined we know there had been some selling pressure causing the downward price drift. That is, those who wanted to sell sold. If the new information was negative it was being priced in. Let's repeat that: when the news has been bad and prices have been falling the perceived bad news was being priced in. These things are always in the past. We can never speak of price trends and news in the future. If we are comparing a direction of price, we must always compare "now" to some point in time in the past. So, people are always experiencing the very recent past and tend to extrapolate it as if whatever happened recently will continue at that pace and direction.

Since I commented about the AAII Survey Shows Investors Bearish, Which is Bullish, which pointed out that individual investor sentiment was negative and that was positive, the stock indexes have gained about 4%. As the crowd suddenly turns afraid after prices have fallen, we know at least some of them have sold, so their fear is getting priced-in to the market as reflected by lower prices.

Now that prices have gained 4%, the AAII Individual Investor Sentiment Survey has turned optimistic again as evidenced by the graph below. After prices rise, they may be thinking "I need to make more money!” The problem is: THEY CAN'T BUY THE PAST. The only choice is now, or not now. We can do nothing in the past and we can do nothing in the future.

source: http://www.aaii.com/sentimentsurvey

The logical inconsistency here is that investors as a group tend to react to falling prices with fear and rising prices with greed. Note that my point here is in regard to the emotional reactions to rising and declining prices and how it relates to sentiment. That isn't to say a portfolio manager shouldn't sell as prices are falling. It isn't to say that a portfolio manager shouldn't buy as prices are rising, either.

Buying things that are rising and selling things that are declining is a proven strategy that is unmatched. It's the emotional extremes in sentiment that causes error. By the time the majority of people (and the media) sounds really pessimistic it's likely too late. They have a tendency to underreact or overreact. Their pessimism is already priced in. If you are getting your feelings from headlines your decisions will probably be far behind the curve. We could say the same about optimism. On April 27th I wrote that "Crowd Sentiment is Optimist: No Surprise to See at Least a Short Term Price Decline". Indeed, the stock indices went on to decline -17% and investor sentiment shifted from really optimistic to afraid and bearish as prices fell.

Keep in mind that we are speaking of emotions of fear and greed here. Investor sentiment can be thought of as a contrarian indicator: when the crowd turns bearish and prices have fallen, we know their pessimism is being priced in. Notice I qualified two things there: price had already fallen and investors were getting afraid and pessimistic about the future as they extrapolate what's happened recently into the future. Investor sentiment rarely turns negative before prices fall. In fact, the data shows investor sentiment is typically at a peak before major declines just as it was in April. The majority (the crowd) is constantly doing the wrong thing and the wrong time.

I am pointing out how emotional reactions relate to price changes primarily for the benefit for people to realize they are likely “one of them” whose sentiment may often be on the wrong side of the tape. However, know that most readers will say “Oh, not me” because of the tendency for overconfidence.  The fact is, most people do poorly at portfolio management as evidenced by studies like this one by Dalbar. If most people create poor results and we are to create good results, we necessarily must be doing something very different than most people. A skilled portfolio manager with an edge will necessarily be be doing things very different that what you think should be done most of the time and that may include over long periods of time.

If investor sentiment is used as a contrary signal to "go the other direction" that's a countertrend signal. Countertrend methods are in conflict with trend-following signals. A countertrend method bets against a trend when it believes an extreme has been reached. A trend-following method rides with the direction of a trend until it changes. A trend-following system will remain positioned in the direction of the price drift until it changes and then it will exit or reverse to the other side. Therefore, a trend-following program will typically give up some of its profits in a position as the price reverses down in some magnitude before its exit point is reached. That is, no one ever knows the top, so you see the top after the fact when it’s reversed down. A countertrend method, such as using sentiment measures and indicators to define an extreme in investor sentiment as overly optimistic or overly bearish, would be contrarian signals for the portfolio manager. The portfolio manager may reduce exposure when the crowd is extremely optimistic or increase exposure to the potential for profit when the crowd appears overly pessimistic. The portfolio manager is basically selling to the crowd when they are willing to pay more and buying from them when the crowd is willing to sell for less. Of course, contrarian type countertrend methods sound good in theory, but they have their risks: even when sentiment is at an extreme it certainly doesn’t assure the opposite will occur immediately. That is why the execution of portfolio management requires skills and talents just as a surgeon, athlete, are business executive. But it's always about probability and mathmatical expectation, not certain outcomes. No investment strategy or portfolio manager can guarantee a profit or protect against loss.

You can probably see how complex decisions can be and why it takes a unique mental state along with vast research and testing to determine if various methods and parameters have a positive expected value (a good enough probability of creating the results that meet your objectives). For example, if a portfolio manager uses investor sentiment to reduce exposure when the crowd is extremely optimistic those things must be defined; what is extreme and how much exposure is reduced? These things can be quantified by quantitative data studies that test them as part of a complete portfolio management system. For me, when there is a directional drift I position capital in the direction of that trend and if it gets to an extreme as defined by several systems I have like sentiment, I may hedge or reduce exposure to the possibility of loss.

A reader emailed a note a few weeks ago commenting that "the current market is uncertain" and he went on to say why he thought so and that he was "watching it closely". He wanted to know if I feel the same.

No. I don't.

So a thank you for HP for his questions and comments and sparking a few thoughts I'll share with you all.

First, I can't assure you of many things, but I can assure of some behavioral and decision-making factors that myself and other asset managers with an edge share. One of them is  related to the comment that "the current market is uncertain". The market is always uncertain. It is never certain. I accept the uncertainty. I accept the risk. To accept the risk requires one to define the risk. For me, the risk I take in any position is defined in absolute terms. So I have determined a certain amount of risk: it's predetermined and known at all times. I know I don't know the future. The future doesn't yet exist. So it is uncertain. But that doesn't keep us from going on and living. We can still understand the probability. However, even though we may know the mathematical odds of one thing or another, that still doesn't make it certain. Each trade or position we take may be uncertain. Know one knows the outcome of a position at the point of entry. No one can control the outcome at the point of entry. That is, you cannot control your outcome by "picking the stock". It's the exit and size that controls the outcome. If a person doesn't believe this, they likely suffer from overoptimism and overconfidence.

The directional trend of the market, and most everything else we do, is uncertain. However, there are ways of dealing with uncertainty. There is a math for it that starts with probability theory. Many people simply haven't studied uncertainty. If I hit my hand with a hammer, I can be pretty sure it's going to hurt.  But I am not sure it will damage my hand. The risk isn't whether it will hurt. The risk is whether it will do damage, or not. You can probably see how we can live with uncertainty and risk if we understand what it is and how to control it.

One of the most fascinating comments I hear a lot is "watching it closely". Once again, we are uncertain about most things. However, I'm pretty sure that "watching it closely" doesn't change the outcome. We can sit and watch a live quote monitor all day but it will unlikely change what the prices do. The investor can log in to their account every day and check the balance, but that doesn't change the outcome. However, the illusion of control may help some think it does. The illusion of control is the tendency for human beings to believe they can control or at least influence outcomes that they have no influence over. Along with illusory superiority and optimism bias, the illusion of control is one of the positive illusions. It seems that "watching it closely" is related to people believing their "high alert" monitoring status will have some positive impact on the outcome just because they are doing it. However, the reality is it probably causes them more mistakes than anything. For example, the waterfall market crash in 2008 and early 2009 was caused by panic selling. Those investors who had held their losses too long began to panic as prices fell lower and lower. The closer they watched the more likely they were to experience every move. They probably sat and closely watched the live financial news TV, too. By "watching it closely" they make sure they react with their emotion. The time to exit was in the early stage of the waterfall, not after it had already declined 50% or more. Yet, the selling pressure from panic selling occured at the lowest prices.

So, what do skilled traders and investment managers do? In all instances, myself and every single portfolio manager that I know that has created good results have no need to "watch it closely". Our decision to enter and exit is already in place. I always know at what point I'll exit and at what point I'll enter...

And... I'll add one more thing. So far 2010 has been a non-trending market state oscillating up and down. Based on our quantitative studies going back 110 years of similar cycles (such as the 18th month of a cyclical bull market) we already knew that "normal" for the first three quarters of this year could be a range bound trend. One way we live so at peace with uncertainty is to define "normal". We have vast studies, which are analog charts of these past cycles averaged together, that give us a picture of what "normal" is at this stage of the intermediate trend. But it isn't that we expect it to repeat with precision. Instead, it defines what is normal. That doesn't give me my expectation, either. My expectation is a function of my historical average profits vs. average losses and has little to do with the market. The bottom line is, we remain in a calm state because we know there is a wide range of possibilities and we always know at what point we'll enter and exit. That is, we don't need to have the illusion of certainty that isn't possible or the illustion of control that one gets from "watching it closely". We are in control of the only thing we can: our decisions. It's from that state that we create asymmetric returns.

Have a great Labor Day weekend!

If we are to have an edge, that is, a decision-making system that creates asymmetric results of higher average profits than losses, we necessary need to be doing things that are very different than the majority of investors. I say that because the majority of investors and traders do poorly at portfolio management over longer term periods. There is no shortage of empirical evidence of the poor long term results of investors and that includes asset managers whose focus is relative performance. If most investors do poorly over time, then those few who create great results must know and do things the majority do not. Indeed, there are so many paradoxes to investing/trading and one of them is that we necessarily must be doing things much different than what most people believe and do.

With that in mind, I came across this report from Dalbar. I think it includes some facts that are useful to never forget. It was the findings from an annual Quantitative Analysis of Investor Behavior report put out by Dalbar each year.

Investors Find No Shelter
DALBAR Study Reveals Carnage for
Equity, Bond and Asset Allocation Shareholders
Boston, MA -(March 9, 2009)

The report states:

By all measures, 2008 was the year that wiped out wealth and DALBAR's Quantitative Analysis of Investor Behavior (QAIB) is no exception. In its 15th annual study of mutual fund investor behavior, DALBAR discovered that equity, fixed income and asset allocation fund investors experienced average annual losses for all time periods examined except the longest (20-year) time frame. And even those positive returns did not keep pace with the average inflation rate.

It goes on to quote the President of Dalbar:

The dramatic events that continue to plague our financial markets have provoked panic, which exacerbates the ongoing carnage," said Lou Harvey, president of DALBAR. "For 15 years, QAIB has shown that investor returns lag what performance reports and prospectuses would lead one to believe is achievable. While those returns are, in fact, theoretically achievable, the reality is that investors are not rational, and make buy and sell decisions at the worst possible moments, he said.

*The emphasis is mine

Amoung the studies findings:

• For the 20 years ended December 31, 2008, equity, fixed income and asset allocation

fund investors had average annual returns of 1.87%, 0.77% and 1.67%, respectively. The

inflation rate averaged 2.89% over that same time period.

• Equity fund investors lost 41.6% last year, compared with 37.7% for the S&P 500 Index.

• Bond fund investors lost 11.7% last year, versus a gain of 5.2% for the Barclays

Aggregate Bond Index. This disparity is largely due to the underperformance of managed

bond funds caused by mortgage-backed securities.

• With an annual loss of 30% last year, asset allocation fund investors fared better than

equity fund investors.

PDF: Investors Find No Shelter _ Dalbar March 2009.pdf

source: http://www.dalbar.com/Portals/dalbar/cache/News/PressReleases/PressReleases20090309.pdf

So says David Wilson at Bloomberg in his recent article: Extreme Pessimism Sets Stage for U.S. Stock Rally: Chart of the Day

He offers a nice chart showing two sentiment polls and explains:

The CHART OF THE DAY displays the results of weekly surveys by the National Association of Active Investment Managers and the American Association of Individual Investors since the beginning of 2009. Each appears in a separate panel.

This week’s reading for the manager index was 13.47, the lowest since March 2009, when the latest bear market in stocks ended. Survey responses can range between 200, indicating that managers are borrowing to profit from stock-market gains, and minus 200, showing the use of leverage to bet against shares.

The top panel tracks the active-manager readings, and the bottom panel shows the percentage of bulls among respondents to the survey of individual investors. The latter dropped this week to 20.9 percent, also the lowest level in 16 months.

Source: Extreme Pessimism Sets Stage for U.S. Stock Rally: Chart of the Day, Bloomberg.

Of course, investor sentiment is a topic I've mentioned a lot the past few months since it has swung from one extreme to another. Back on April 27th, before the -17% decline in market indexes, I posted Crowd Sentiment is Optimistic: No Surprise to See at Least a Short Term Price Decline. Investor optimism had hit an extreme optimistic level, and sure enough it preceded declining stock prices. As evidenced by sentiment polls like those in the chart, since stocks have now fallen the optimism changed to pessimism. We've also seen a lot of magazine covers with bearish tones, for example, the one I mentioned in Magazine Cover is a Bullish Signal for Crowd Sentiment.

As I've mentioned before, in order for prices to reverse back up to a new rising trend, buying demand simply needs to overcome selling pressure. These sentiment polls continue to show that investors, both professional and individuals, feel negative about the direction of the market. As their sentiment gets to an extreme they tend to over-react, eventually driving prices low enough to attract buying demand from those of us who raised cash when the crowd was extremely bullish.

However, there is no better measure of investor sentiment than the current direction of prices. As I've stated previously, sentiment alone isn't the best signal. The crowd can be right for some time. Sentiment can always get more extreme. Sentiment is confirming evidence of price action - don't fight the tape. The actual price direction is the judge and the jury, so that's our main guide. It appears in the days ahead we'll likely see if sentiment is negative enough to set the stage for a continuation to the upside, or if prices need to go lower to attract sustained buying interest.

I previously posted A Blast from the Past: Panic Selling the Week of October 6, 2008. It was a fine example of the negative sentiment during the lowest price points of the October 2008 waterfall. Jim Cramer capitulated on national television, telling America:

"Whatever money you may need for the next five years, please take it out of the stock market right now, this week. I do not believe that you should risk those assets in the stock market right now.”"

Note: that was near the lowest, low, and the stock market indexes were already down over 40%. Stocks went on to make a large (though volatile) move to the upside afterward. Clearly, Cramer is led by him emotion and those emotional rants he does on his TV show attract emotional people to watch him. It's a herding effect. 

Cramer, or his, friends must be short the stock market. He seems highly upset that the stock market rallied yesterday. I say this because Cramer normally talks a lot more about "Buy, buy, buy", well, until prices get to a major low after panic selling: then he tells all of America to sell. A hat tip to David Joe for pointing out a post by Tyler Duran over at ZeroHedge titled Cramer Calls Market "Stupid, Rapacious, Arbitrary, Capricious And Downright Ridiculous", Tells Viewers To Stay Out.

Cramer now says:

"I'm calling this a bad rally..."

"This market is stupid. And it is hated for a very good reason. The market seems rapacious, arbitrary, capricious and downright ridiculous. It is a tale told by an idiot, full of sound and fury, signifying nothing."

 Cramer seems flustered when he doesn't feel like he has a grasp on what's going on. But the future is always uncertain, so you can't figure it out. It doesn't yet exist; that makes it unknowable. Mr Cramer: Just let it go and adapt to the changes as they come. Or, better yet, we'd prefer you and your viewers to under-react to the moves that will cause directional drift - the trends we want to ride.

A message to Mr. Cramer: the market is the collection of the people who make it up, it isn't a "thing", a being, or an index. You can disagree with the people and fight the tape, but at the end of the day you will find, as you have before, that price is determined by the casting of votes by market participants and that is both the judge and the jury. Your opinion and sentiment, like any non-price derived signal, can stray far, far, away from "what is".

It appears that Jim Cramer has added to our collection of evidence that we just might see some upside to stocks in the weeks or months ahead... the market does tend to climb a wall of worry. It seems the evidence appears to be mounting that investor fear and negative sentiment has gotten pessimistic enough to potentially drive stocks to a higher level. Of course, fear and selling alone can't do it. Buying demand will need to overcome selling pressure and we've seen that recently. But as I stated in Drawing the Line in the Sand for the Stock Market: A Look at the S&P 500 Index Trend if the volatile action over the past two months is indeed topping action that leads to a reveral down of the upward primary trend that started in March 2009, we believe it may be evidenced by a "Head & Shoulders" formation that is very common at major market peaks. That is, stocks could rally up to around the 1150 range on the S&P seen in the "left shoulder" in January... and then reverse back down again.

We'll see...

One of the most fascinating things that serves as a demonstration of feeling the wrong thing at the wrong time is magazine covers. When extreme sentiment shows up on the cover of magazines, it's often a signal of a trend change. Indeed, below is the cover of The Economist issue for the next week, May 29th - June 4th, titled "Fear Returns". After I commented "Crowd Sentiment is Optimistic: No Surprise to See at Least a Short Term Price Decline" one month ago on April 27th which was early in the stage of this correction, it seems this magazine may be what my grandfather used to call "A day late and a dollar short". The Economist may be right this time: maybe a double dip recession is next, but we know that historically when we've observed their bold covers, it's often evidence of crowd sentiment and crowds are mostly wrong at an extreme. Of course, directional price drift will ultimately be the judge and the jury, so we follow its lead.

Source: http://www.economist.com/printedition/displayCover.cfm?url=/images/20100529/20100529issuecovUS400.jpg

Last Thursday I commented:

"Crowd Sentiment is Optimistic: No Surprise to See at Least a Short Term Price Decline"

After the close that same day, I commented "Today’s Stock Market Decline is about Twice a “Normal” Move "  when I concluded about the days market action "today we get at least a warning shot across the bow."

That post suggested that investor optimism had hit a extreme short term peak; a level that historically preceeds a correction (decline) in stock prices or at least low returns for a while. Indeed, it appears the former is underway. The chart below represents the S&P 500 Stock Index. It is a daily chart showing the price trend since December. As you can see, the most recent price action for this stock index shows a decline of -6% over the past 2 weeks. This same index declined about 9% in Jan - Feb before reversing back up to a higher high. As evidenced by the other posts I made last week , corrections of 5% - 10% are fairly common in a Cyclical Bull primary trend. With that said, we have reduced our exposure to loss over the last week.

It’s a good time for a blast from the past. Someone recently reminded me of the Jim Crammer panic sell recommendation October 6, 2008 on the Today show.

Cramer Said:

“Whatever money you may need for the next five years, please take it out of the stock market right now, this week. I do not believe that you should risk those assets in the stock market right now.”

You can hear him say it and how he said it here:

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This video is a fine example of the panic selling that occured that week by those who had over-stayed their positions through the waterfall (or "bloodbath" as some call it).

Below is a monthly chart of the S&P 500 Stock Index. The time period starts in 2007 to show the stock market peak and includes the lowest low on March 2009, which is presumably "the bottom". The red arrow helps to highlight the downward drift of this index from its peak in October 2007 to the date Jim Cramer was on the Today show saying "sell".

1. As we can see, this stock index had already declined about -42% by the time Cramer made his panic sell call.

2. We can also see, in hindsight, that the panic was near the lowest low. Although the index did decline further, it had already declined much more. We also see that the index has now gained 40% from that "sell" cry.

 A few more points that I want to make:

1. Clearly, panic sellers like Cramer eventually push down prices to a low enough point that others who held their positions too long panic, too, causing lower and lower prices. Eventually, those same panic sellers push down prices low enough to attract new demand.

2. I want to highlight an important requirement for a person to get caught in this loss trap: in order to panic like they did, they had to have held too long. That is, if you exited early in the stage of the waterfall, then you are in cash awaiting lower prices and a reversal of the waterfall.

3. Everyone has an uncle point, an exit: it can be the predetermined like mine are, or it can be after a large loss, or it may be zero. I prefer to know every day at what point I'll exit a position that is moving against me.

For more information, or questions, feel free to post a comment.