Market Sentiment’s Worth as a Directional Indicator

By on October 1, 2006

Originally published in December 1998:

INDEXES ON 11/30/98

DJIA 9,116.55

S&P 500 1,163.63

NASDAQ 1,949.54

Editorial

The market’s strength has surprised me. I guess I’ll have to apologize to Abby Joseph Cohen, the world famous Goldman Sachs market prognosticator, strategist and partner. Her prediction of an 1150 level on the S&P 500 index by the end of the year is going to be pretty darn close. At least it looks that way now. There was only one timing signal in November, so things have settled down substantially from the frenetic market activity we witnessed in the late summer and early fall. However, the swoon which occurred on the last day of the month may be a harbinger of increased volatility and a pronounced weakness in equities. The activity in the internet group is reminiscent of some other extraordinary bubbles of the past. When these things pop it can effect the whole market, as leveraged investors receive margin calls and are forced to sell in order to cover them.

Market Sentiment’s Worth as a Directional Indicator

Some investors persistently search for the ultimate indicator of market direction. Many attempt to use market sentiment indicators to get a gauge of where the market is heading. I used to look in Barron’s every week for the Investor’s Intelligence, Consensus Index, AAII Index and Market Vane reports to measure the number of bullish, bearish and neutral investors. I never found them to be of much use. The data was simply too stale to signal a change in market direction. This is not to say that it is completely worthless information. Whenever more than 60% of investors are bullish or bearish it generally pays to make your market bets directly opposite to the direction the crowd is leaning towards. The reasoning goes that if the vast majority of investors are bullish they’ve invested as much as their risk tolerance will allow. Likewise, if sentiment is extraordinarily bearish, investors have probably lightened up substantially on their stock holdings, leaving a lot of buying power available if conditions change. Interestingly enough, the best measure of bullish and bearish sentiment is the level of stock prices relative to their recent history. If stocks have skyrocketed like they have lately, it’s obvious that bullishness has risen, and vice versa in a decline. So rather than being a leading indicator of a stock trend, sentiment is a following indicator. It is better to focus efforts on developing relational indicators based on known factors instead of those that are strongly influenced by movement in share prices. I’m currently developing what may possibly be a very powerful relationship between a certain money flow which is known in advance, and the movement in a subset of stocks. This indicator has the potential of adding 10 percentage points or more to annual returns which would create an extraordinary advantage over buy and hold.

If you insist on following sentiment there are a few internet sites I’ve found that can give you very timely information regarding the mood of investors. The sites take polls of investors who visit their internet address. The Lowrisk.com pollees are generally more bearish than the other two sites probably due to the nature of the service and the message of its publisher. Bob Brinker and Louis Rukeyser are more upbeat than the average prognosticator and it rubs off on their subscribers. I’m not saying these polls are scientific and statistically accurate, but they can provide a general idea on the leanings of the investing public. Before the 216 point decline on the Dow a composite of these polls showed 85% of investors were bullish, whereas only 58% were bullish on November 22. Go to these sites to see for yourself:

Wall $treet Week With Louis Rukeyser @ http://www.pbs.org/mpt/rukeyser/elves.html

Bob Brinker’s Marketimer @ http://www.bobbrinker.com/pollresults.asp

Lowrisk.com @ http://www.lowrisk.com/sentiment.htm

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