“The crowd is right in the trends and wrong at the ends” as the old Wall Street saying goes.
To achieve a quick sense of the balance of power in the market, a technical trader may often wish to lay aside the charts and graphs for a time and examine other information to gain an overall perspective on the bulls and the bears. A common and widely accepted means of ascertaining this balance of power is to take a quick reading of a sentiment index, the most prevalent of which is the Investors Intelligence reported figure, which is published by Chartcraft. There are many more, but two others of significance are the AAII Investor Sentiment Survey and the NAAIM Sentiment poll, which are discussed in more detail below.
Defining Crowd Sentiment and Investor Sentiment
Crowd sentiment, or investor sentiment, or market sentiment, refers to the tone of a market (crowd psychology). It is ultimately shown by the price movement of securities. For example, rising prices reflect bullish market sentiment and falling prices reflect bearish sentiment.
Meaning of Sentiment Indicators
Sentiment indicators are used to gauge the attitude and tone of investors and how they perceive the current health in the market outside of simple price activity. Sentiment indicators are used to quantify the level or pessimism or optimism about the future direction of the stock market.
There are many ways to measure sentiment to produce sentiment indicators. A number of surveys track the sentiment of analysts, mutual fund managers, and newsletter writers. When a significant majority of survey respondents share the same sentiment, a market turn may be imminent. For example, the Put/Call Ratio, which measures trading activity in puts and calls, signals high levels of bearish sentiment when put buying is much heavier than call buying. There many other sentiment indicators that measure the sentiment of individual investors, investment advisors, and consumers.
Sentiment Indicators and Investors
Some sentiment indicators are created by taking an actual poll of investors. Either way, investor sentiment indicators are contrary indicators, or counter-trend indicators. When investor optimism or pessimism is at an extreme, it's a strong indication to do the opposite.
For example, in October 2007 at the most recent stock market peak, investor sentiment was very optimistic. After all, it was the fifth year of a rising stock market. Investors tend to project the recent past into the future. But in March 2009, investor sentiment readings, according to sentiment indicators, recorded some of the most extreme pessimistic levels ever recorded. After a -56% decline in the S&P 500 stock index from October 2007, investors again projected that waterfall to continue. From March 2009 through March 2010, that same index had gained nearly 70%. Although you wouldn't necessarily use this indicator alone in attempt to pick a top or bottom, clearly when the crowd is at the panic state or in a state of euphoria, these extremes tend to mark a change of trend. This is at least true in hindsight.
A note of interest is that, when investors are extremely fearful about the market as they were in March 2009, the same was true long before the low was made.
In addition, when fear is at an extreme, that doesn't necessarily mean one can tolerate the potential risk at the lowest low. That is, when selling pressure is strong enough to push prices to such a low, you don't know until after the fact what "the low" is. For example, you may have not yet seen it.
Traders and the Use of Sentiment Indicators
Traders will use a variety of tools and methods for assessing the sentiment of a given security. Some sentiment indicators are based on other market factors like the Put/Call ratio. One method is to analyze the put/call spread on a security to gauge how traders are feeling about a stock.
Traders will also use the premium of stock index futures relative to the price of the security itself to gauge investor sentiment. One of the little known sentiment indicators is to track the current market views of investment newsletters.
Many traders will wait for advisory services to all go extremely bearish or bullish, and then fade their signals. This method of trading works quite well, because if the majority of traders are thinking the same thing, odds are the supply demand forces in the market are imbalanced.
Using Sentiment Indicators to Predict Stock Returns
The strongest tests of the effects of sentiment involves return predictability. If high sentiment indeed causes overvaluation, we may be able to document low future returns on sentiment-prone stocks as sentiment wanes and fundamentals are revealed. Predictability is not a natural implication of the skeptical view that the correlation between returns and sentiment indices arises because the latter are contaminated by fundamentals, for example.
Conclusion of Sentiment Indicators
When investor optimism is at the high point that has historically resulted in a short term peak in prices and a reversal, this is the point of highest risk. That is, just when most investors are feeling really optimistic about future stocks prices and the majority of them have stocked up, that’s about the time the prevailing trend changes. By the time a high level of excitement is at historical highs the last buyers have entered and most of the gains have already been made.
It may be beneficial to use sentiment indicators as measures for a trading signal, but an alternative method instead, is to use sentiment indicators 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. Extreme levels are an extra "setup" for us to take notice and prepare to reverse position. 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.
"...a good contrarian indicator: When sentiment reaches extremes it’s usually a good idea to bet against the crowd, and with the minority."
Below are examples of investor’s sentiment surveys that are created by a poll.
Purpose of AAII as a Sentiment Indicator
The AAII sentiment survey is a weekly poll conducted by that organization which intends to gauge the overall sentiment of their membership. They ask their membership where they think the market will be in six months, and group the responses into three categories: bullish, bearish or neutral.
The AAII (American Association of Individual Investors) is a non-profit organization headquartered in Chicago, and was founded in 1978. James Cloonan, Ph.D., founded AAII because he firmly believed that individual investors armed with effective investment education materials and a bit of dedication could outperform the popular market averages.
Their stated mission is: "assisting individuals in becoming effective managers of their own assets through programs of education, information, and research."
It is affiliated with NAIC, the organization that helped so many investment clubs get started in the late 1990's.
Over thirty years later, the 150,000 members of AAII report investment returns that are consistently higher than those of the stock market as a whole.
Further reinforcing Dr. Cloonan's point, AAII's Shadow Stock and Mutual Fund Portfolios (real portfolios used to teach members about investing) have had lower risk scores and better returns than the S&P 500 for the last 10 years.
However, it is obvious that their niche market is individual investors, and not professional traders, pension funds, or anything else institutional. Their focus, and the focus of the greater majority of their membership, is long-term fundamental analysis of sound companies using a very minimal amount of technical analysis for decision-making purposes.
Like most contrarians indicators, when the survey shows too many investors as being bullish, it very often corresponds to market highs. Conversely, too many bears suggest that the market may soon find a low.
As the survey has a noisy week-to-week nature then it is recommended that you use other indicators in parallel.
For further reading here is the web-site for AAII.
Investors Intelligence is a leading provider of research and technical analysis into the price movements, trends and timing changes of stocks, currencies, commodities and financial futures.
The object of their existence is to generate consistently valuable and accurate investment research for clients, helping them make informed, and better, investment decisions.
The analysis of US stock and market trends is conducted through their US offices of Chartcraft Inc, founded in 1947 by the legendary A W Cohen. The US operation has been at the forefront of developing analytical tools which are now in common use – the NYSE Bullish percentage; the Advisory Sentiment Index; the Broad Industry Group Bullish percentages; and the Industry Group Insider Analysis.
The other services for the Investors Intelligence global offering are provided by Stockcube Research Limited.
They employ fifteen full-time analysts who each day, with the help of sophisticated technological support, analyzes over 10,000 stocks and financial instruments for the benefit of subscribers. Their systems and software are proprietary and written and supported by a team of nine expert programmers and software designers accessing our servers in the UK and the USA.
Picture:A Meeting of Analysts
Chartcraft Inc and Stockcube Research Limited are wholly owned subsidiaries of Stockcube plc, a UK company based in London.
The Research Methodology Employed
Investors Intelligence is a source of independent analysis on the financial markets. Their primary focus is that of technical analysis, this being the study of price action. Utilizing their in-house systems, charts and tools, their analysts review the markets on a regular basis, seeking to identify trading and investment opportunities at the level of index, sector, pair and individual instruments.
A variety of disciplines are utilized including, but not limited to:
• Identification of trend through automated and/or visual review of price charts;
• Identification of relative performance through automated and/or visual review of relative ratio charts;
• Automated scanners, identifying various technical signals including P&F breakouts, Key Day Reversals, MA crossovers and Buy/Sell Climaxes;
• Volume and momentum indicators;
• Breadth analysis of indices, groups of stocks and other financial instruments;
• Their proprietary Advisors Sentiment survey.
The techniques may vary across the range of financial markets, depending on the suitability or viability of each technique to the relevant market.
Buy & Sell Recommendations
Investors Intelligence analysts will make both "Buy" and "Sell" recommendations in their reports. These are based on the technical analysis methodology and identify areas where they believe that there is a good probability of a successful trade or investment. Please note that "Sell" recommendations can refer to both disposals and short-side trades and each report should be examined to determine the nature of the recommendation.
The time period of recommendations is variable and can be dictated by the markets. Where possible, Investors Intelligence analysts will provide technically derived stop levels and targets.
A History of Innovation
Since pioneering the use of point & figure charting in the 1950s, many of their analytical tools have become industry standards, such as the NYSE Bullish % and the Advisors Sentiment Survey. They now produce technical analysis based advisories for the majority of international financial markets. Their services are subscribed to by investors, traders and financial professionals around the world.
The National Association of Active Investment Managers or NAAIM was formed in 1989 as a non-profit association of registered investment advisors, who provide active money management services to their clients, in order to produce favorable risk-adjusted returns as an alternative to more passive, buy and hold strategies. Originally called SAAFTI and comprised of a small group of successful, passionate firms, NAAIM has grown to include roughly 200 member firms nationwide, managing over $30 billion. NAAIM's purpose is to promote the common interests of those investment advisors who provide active investment management services to clients.
The Role of NAAIM
NAAIM defines "active investment management services" as taking an active role in the ongoing process of investment selection and risk management with the objective of improving a portfolio's risk/reward relationship. The active management strategies used by their members are diverse, and utilize a broad range of securities including mutual funds, variable annuities, equity baskets, index-linked, exchange-traded securities, futures and other innovative products.
NAAIM's membership ranges from small regional firms to large national firms with over $1b AUM, including hedge fund managers, mutual fund companies and a variety of other firms that provide professional services to RIAs.
As an organization, NAAIM engages in numerous activities to promote active management and further the professional development of its members, including:
Acquiring, preserving and disseminating valuable information relative to, or useful in providing, active investment management services;
Providing the opportunity for members to exchange information, experiences and opinions through discussions, meetings, study and publications;
Keeping its members informed of legislative and administrative changes affecting investment advisory services, and representing their interests in the formulation of policy affecting such services;
Developing and encouraging the practice of high standards of personal and professional conduct among members and the public;
Educating the public with regard to the concept and benefits of active investment management services and promoting the public's use of such services.
We have the American Association of Individual Investors, Investors Intelligence (newsletter writers), and Wall Street Sentiment (technically oriented message board participants). All these polls are based upon opinions, not actual money deployed. With this in mind I think that the NAAIM Sentiment poll adds a new and useful dimension to sentiment analysis.
NAAIM has been collecting data since 2006. Approximately 40 NAAIM member firms who are active money managers are asked each week to provide a number which represents their overall equity exposure at the market close on Wednesday. Responses can vary widely as indicated below.
Responses are tallied and averaged to provide the average long (or short) position or all participating NAAIM managers, as a group. Note that these are "active" managers, not those who are tasked to be 100% invested 100% of the time. Range of responses:
• 200% Leveraged Short
• 100% Fully Short
• 0% to 100% Cash or Hedged to Market Neutral
• 100% Fully Invested
• 200% Leveraged Long
It needs to be understood that, for the most part, the members react to market trends rather than anticipate them. One exception where this occurred was the statement for the last quarter of 2009, where exposure contracted ahead of the January 2010 correction. Let me clarify that for people to react to trends is normal behavior, and it is reflected in all sentiment polls. When too many people are bullish or bearish, we need to be alert for possible trend changes; however, the majority can be right for quite a long time before the market turns.
The NAAIM Survey of Manager Sentiment is a useful addition to your array of sentiment indicators because it shows to what extent professional money managers are actually deploying money.
For further reading here is the web-site for NAAIM.
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