Through The Fly's Eyes: Market Sentiment
A Technical View
There are many ways to measure sentiment in terms of market participants. One can be direct, such as we will discuss today, which is based on the relative "bearish" or "bullish" state of advisors who produce newsletters or other forms of analysis that are marketed to investors of all stripes. This is typically referred to as "advisory" sentiment.
One of the most commonly followed indexes of advisory sentiment is produced by Investors Intelligence. We will be looking at that index along with a chart of the S&P 500. There are other services that provide these sorts of indexes, including the Market Vane "Bullish Consensus"
and Consensus Inc's "Bullish Opinion". Barron's publishes these numbers each week. High numbers in these indexes usually occur near tops, low numbers at bottoms.
There are also surveys that take the pulse of investors in an even more direct manner, such as the UBS "Index of Investor Optimism" and the American Association of Individual Investors "AAII Index". Again, high numbers tend to occur closer to tops, low numbers at bottoms.
In a future piece we will look at other measures such as volatility indexes of various kinds, put/call ratios and the Commitments of Traders report (COT) produced by the CFTC.
Referring to the chart, we can see that peaks in the Investors Intelligence Bulls index (top panel of the chart) tend to take place in the high 50s to 60s. Troughs can form at a variety of levels, however the low 40s to 30s are generally excellent long entry points. What is this measuring exactly? Why are high numbers "bad" and low numbers "good"?
The traditional interpretation of the index is based on "contrarian" thinking. In this case, when advisors are at their most bullish (when the numbers are relatively high) the assumption is that money has already been committed so that very few investors are not already "long", or invested in, the market. Without new money flows, markets have a tough time advancing, and so high numbers will warn that the advance in prices may have reached a peak so that it becomes time to sell-off positions and take profits. This is harder to do than it sounds as people will have been making "easy money", the markets will "look great" at this point, news will tend to be very positive and there will seemingly be few apparent reasons to sell. The inverse is true when the advisory numbers are relatively low. When this happens, which as can be seen is relatively rare as are peaks, it will likely mean that the markets have been under-performing or doing very poorly and that advisors can see no reason to add to long positions. It is likely that investors at this stage will have endured losses and have been selling their stocks off, the markets "look bad", news will tend to be the worst imaginable, and there will be no apparent reasons to buy. Contrarian thinking suggests that this is exactly the time to start buying.
So what does this mean as we head into 2007? As we can see on the chart the bullish numbers are relatively high. We have seen a cluster of these as well of late, which has been typical of the pattern at tops. While there is no certain way to tell if this simply means a pause in the advance or something more severe cannot be predicted from the index values alone. The reason for this is that it is the duration, the process, of the shift in thinking from bullish to bearish (and vice
versa) that can have a lot to do with the depth of a rally or a sell-off. Further, these trends in oscillation from bullish to bearish can take a great deal of time. The markets can drift further in the direction of the trend well after the numbers have peaked or troughed.
The cycles can take months to years to conclude once underway, so this tends to be something to monitor over a long period of time. Further, the "trend" of the numbers is just as important as their value (which tend to work best at extremes as indicated on the dashed lines of the upper panel).
What we can take away, especially given that the Investors Intelligence bullish readings are high, the Market Vane numbers are near record, and that the Bullish Opinion numbers are high (58, 73 and 67 respectively) is that there is a risk of a top being put in place and that at the least a defensive posture is wise. It may be time to think about easing out of positions that have yielded profits and waiting for more favorable entry points before going long further.