In "Investor Sentiment" I pointed out an elevated level of sentiment. As sentiment studies show, most people tend to do the wrong thing at the wrong time. Below is a video that does a fine job at explaining how to use sentiment.
If every instinct you have is wrong, then the opposite would have to be right...
Or, click HERE.
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
This is interesting... Recall a few weeks ago that more professional advisors turned bullish as mentioned in Bears Turn to Bulls: Most Advisors are Just as Emotional. Barron's cover is bullsh, though they actually sound a little conflicted. The big bull is stepping on the bear. They say:
America's money managers are bullish in Barron's latest Big Money poll, but picking their spots with care. The crowd is seeking safety in big, defensive stocks.
That's the message of our latest Big Money poll, which finds nearly 60% of America's money managers bullish about the stock market's prospects through the end of the year, but muted in their expectations of how high stocks can rise from here.
Source: click HERE to read the full article (subscription required)
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:
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
Once again, investor sentiment changes after a drift in market prices. Investors were previously optimistic about future prices, but after a decline in stocks the past few days their optimism plunged into pessimism. Investors have emotional reactions to a drift in price (trend) and it's mostly fear: at times they fear losing money and sometimes they fear missing out. This weeks survey provides an example of how sharply their fear can sway in one direction of another. The point I make is that when investors sentiment gets to an extreme, it's an early warning sign that a price trend may soon reverse. As I've stated before, when the majority becomes bullish they'll eventually represent the last buying demand and all that's left is selling pressure. It's important to understand the context in which I'm point this out: as a group, investors opinion about the furture largely illustrates their emotional decision-making process and their underreaction. It's a subjective function of their fear of being wrong, loss, or missing out. Investor sentiment measures can be quantified to learn their probability and used in the process of active risk management.
Charles Rotblut, CFA of AAII provides a great summary:
Bullish sentiment, expectations that stock prices will rise over the next six months, plunged 9.9 percentage points to 36.6% in the latest AAII Sentiment Survey. This is the first time in 25 weeks that optimism has been below its historical average of 39%.
Neutral sentiment, expectations that stock prices will remain essentially flat over the next six months, edged down 0.6 percentage points to 27.2%. This is the 29th consecutive week that neutral sentiment has remained below its historical average of 31%.
Bearish sentiment, expectations that stock prices will fall over the next six months, surged 10.7 percentage points to 36.2%. Pessimism is at its highest level since September 2, 2010. This is just the fourth time in the past 24 weeks that bearish sentiment has been above its historical average of 30%.
Charles goes on to summarize some of the emotional comments from the survey below. I point out (by making the words bold) the usefulness of noting their fear of being wrong or missing out.
The ongoing instability in the Middle East is intensifying concern about higher rates of inflation. Individual investors are already seeing higher gas prices at the pump, and there is worry that even higher prices could slow down the pace of the economic recovery. Though AAII members had been optimistic about the direction of stock prices, there was underlying unease about jobs, the federal deficit and the potential for rising interest rates and inflation. Thus, though individual investors were hopeful, they were not exuberant.
Source: AAII
A pullback in stock prices should be no surprise. Investor optimism the past several months has been far above its historical average and at a level that normally precedes at least a short term trend reversal to declining prices. In fact, the current 21-week streak of consecutive above average optimism is the second longest in the 33 year history of the AAII Investor Sentiment Survey. When the crowd gets overly optimistic, prices tend to fall. As this current Cyclical Bull Market is peaking out, this is just one sign of evidence a reversal in the primary trend may be closer than many investors believe. Investor sentiment, their beliefs about the future direction of the market, reflects where the market has been, not where it is going. Investors tend to extrapolate the recent past into the future. As primary market trends reach their peaks, investors become overconfident, overly optimistic, and they over-react. This behavior is evident by the price action and sentiment at major turning points. Charles Rotblut of AAII describes the current survey: (I bold key points)
Bullish sentiment fell to a 10-week low in the latest AAII Sentiment Survey. Expectations that stock prices will rise over the next six months fell 8.7 percentage points to 42.0%. Despite the decrease, bullish sentiment remains above its historical average for the 21st consecutive week. This is the second longest streak for above-average bullish sentiment since the survey began in 1987.
Neutral sentiment, expectations that stock prices will stay essentially flat over the next six months, rose 3.5 percentage points to 23.7%. Nonetheless, neutral sentiment remains below its historical average of 31% for the 25th consecutive week.
Bearish sentiment, expectations that stock prices will fall over the next six months, rose 5.2 percentage points to 34.3%. This is the highest level of pessimism since September 2, 2010. It is also only the fourth week since then that bearish sentiment has been above its historical average of 30%.
Bearish sentiment has nearly doubled over the past four weeks, from 18.3% on January 6 to 34.3% now. Though this does somewhat reflect a reversion to the mean, it also shows that some investors are becoming less enthusiastic about the short-term direction of the stock market. The length of the rally, the 1% decline in the S&P 500 last Wednesday (January 19), and the level of optimism signaled by the various sentiment surveys-including ours-are all contributing factors.
It is important to note, however, that bullish sentiment continues to stay above its historical average. The current 21-week streak of above-average bullish sentiment is the second longest such streak in the survey's history
The AAII Sentiment Survey has been conducted weekly since July 1987 and asks AAII members whether they think stock prices will rise, remain essentially flat, or fall over the next six months. The survey period runs from Thursday (12:01 a.m.) to Wednesday (11:59 p.m.). The survey and its results are available online here.
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.
The AAII Investor Sentiment Survey measures the percentage of individual investors who are bullish, bearish, and neutral on the stock market for the next six months; individuals are polled from the ranks of the AAII membership on a weekly basis. Only one vote per member is accepted in each weekly voting period.
For the week ending 9/1/2010 investors continue to be more bearish than bullish, though they aren't as bearish as the previous week when 49.47% were bearish and only 20% bullish.
The stock market is group psychology in motion. Although some may believe "the market" is some index like the Dow Jones Industrial Average: it isn't. The market is the collection of people that trade in it. Investor Sentiment surveys are mostly useful at extreme levels of optimism or pessimism. By the time the crowd is negative, those who desire to sell have already sold. By the time the crowd is euphoric, most of those who want "in" already are. Therefore, the risk or negative information they perceive is already priced in. At extremes in opinion, the stock majority is wrong. By definition, a bottom in the stock market is point of maximum pessimism (bearishness) and the top in the market is the point of maximum optimism (bullishness). I will sometimes comment on the surveys when they have reached a point our historical studies define as extreme, when it may be used as a contrary signal to be alert for a trend reversal. It's interesting to watch how these extremes lead to reversals.
Source: http://www.aaii.com/sentimentsurvey
See past results of the AAII Investor Sentiment Survey: http://www.aaii.com/sentimentsurvey/sent_results
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.
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...
On May 28th I posted the cover of The Economist magazine that pictured a shark swimming in the water with the headline "Fear Returns: How to avoid a double dip recession". I called that post Magazine Cover is a Bullish Signal for Crowd Sentiment suggesting the negatively toned magazine cover may be a positive. You see, by the time information hits the cover of the magazine and the public hears it, it isn't "new" anymore. Their sentiment is a countertrend indicator. We give a hat tip to Lee Edgcomb for pointing out another bearish magazine cover just released. Below we show the cover of Bloomberg Businessweek. Of course, for our purposes we are only making reference to the cover, not the content. The article was written by Jessica Silver-Greenberg and can be read in the link below the cover.
Source: http://www.businessweek.com/magazine/content/10_25/b4183048417437.htm
I have empirical evidence that bearish magazine covers like these often mark the lows of a stock market correction and bullish covers are seen at peaks. I say this because I've witnessed it enough times in the past 15 years that it's become a contrary sentiment indicator for me. It's simply an indication of sentiment as the editors of these magazines are no more on the right side of the trend than the average person. We give another hat tip to Nicholas Manley, who is a student at the University of Richmond, who reminded me of a study completed by some professors at his school. Tom Arnold, CFA, John H. Earl, Jr., CFA, and David S. North found: “Statistical testing implied that positive stories generally indicate the end of superior performance and negative news generally indicates the end of poor performance.” To learn more about this study, read: Are Cover Stories Effective Contrarian Indicators?
As you will hear me say often: "If we are to have an advantage in the market, we necessarily need to do things others aren't. About 80% of the time, I'm going to do the complete opposite of the thing you think I should be doing". For me, that means I'll be going with the flow in the direction of the trend until its end when the sentiment gets to an extreme when I'll perk up in preparation for the trend to reverse. When it does, so do I...
Speaking of trend, I guess with the recent sentiment showing a lot of fear it is no surprise to see today's 2%+ rise in the popular stock indexes. You see, a reversal of the downtrend since April will occur once those who want to sell have sold and buying demand overcomes the selling pressure. It's a good time to offer an update from what I wrote on May 25th: A Follow Up on the Stock Market… and a Word on Loss Traps and Risk Management and Drawing the Line in the Sand for the Stock Market: A Look at the S&P 500 Index Trend (when you see the words are a different color, that means you can click on them to revisit the prior post).
You should probably revisit the prior comments to understand what the chart below says about "now". As you can see, today's action was a breakout to the upside, so we now at least have a higher high in the short run. It appears more likely this price may continue to advance for a while. The relatively high level of fear among investors recently seems to support that hypothesis. 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
Yes, you read that correctly. When investors get scared, that's a good thing for stocks. When investors are optimistic, that's negative. That's just the way it works. And we're going to show you here, over and over again.
A few weeks ago in Crowd Sentiment is Optimistic: No Surprise to See at Least a Short Term Price Decline I noted that our measures of investor sentiment signaled a high level of optimism that historically precedes a correction for the stock market. When “the market” gets too excited, as they often do after prices have risen in the recent past, that’s about the time a rising trend in stock prices reverses to the downside. At Shell Capital, we like to go with the flow of the prevailing trend by staying on the right side of the directional drift and then we adapt to directional changes in price. That is, we don’t fight the tape. But when we see signs of people getting to greedy, that’s when we start to “set up” and pay attention- aware of a potential reversal. Though we have quantitative systems that measure a wide range of investors’ fear and greed, we also get important signals from the comments from people. For example, we pay attention when comments from investors are about how much money they’ve made or could have made, or should have made in the recent past. When optimism gets to an extreme, we aren't surprised when prices move in the opposite direction. And when the direction does change, we're changing with it. A few weeks ago, I suggested that investors' high level of optimism suggested a correction was likely.
But that was then, this is now. A fundamental edge we have here at Shell Capital is that we live in the "now". We make decisions in moments of "now". We can do nothing in the past. We can only do things now, or not now: that’s the only choice we have. A quarterback can only throw the ball right then. He can’t do it the day after the game. He can’t do it in the future, either. He can visualize how he’ll throw the ball in the future, and that may be useful mental rehearsal for him and mental rehearsal may be a part of his advantage. But when the time comes, he can either throw, or not throw. And the choice is right now. We live in moments of now. It's a big advantage for me: I know the secret to human decision-making: it’s now, or not. That's the choice. You can probably see how simple my decisions are...
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.
In the past few days, our indicator of crowd sentiment suggested that Investor optimism is at the high point that has historically resulted in a short term peak in prices, and a reversal. That is, just when most investors are feeling really optimistic about future stocks prices and the majority of them have piled on, that’s about the time the prevailing trend changes. Investor sentiment is a countertrend indicator, or a contrarian indicator. By the time that level of excitement is high, the last buyers have bought, and most of the gains have been made. So it isn’t unusual to see prices at least reverse on a short term basis as we saw today.
We do not, however, use sentiment measures as a trading signal, but instead, as a warning signal or as confirmation of price based signals. It allows us to quantify “How do we define overly optimistic” with the answer: When the indicator is at the same extreme level that has historically led to a reversal in prices. Other than that, we go with the flow of the prevailing price trend until it changes, and when we see these extreme measures of inventor psychology then we know not to be surprised if the trend changes soon. We also know that low readings (extreme bearishness) have been associated with better than average price increase in the S&P 500, while high readings (extreme bullishness) have been associated with declines (or at least little positive change).
Our sentiment indicator is designed to highlight shorter term (more recent) swings in investor psychology; optimistic (bearish) about the market’s direction or pessimistic (bearish). The composite is based on seven different individual sentiment indicators in order to represent the psychology of a wide range of investors.
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.
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