Sentiment Indicators for Contrarians

Stock Market Sentiment Indicators to Watch Now



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sentiment indicators

October 20th, 2011

The volatility rollercoaster for the equity markets continues to bombard the investor and the search for a solution to combat this situation, in the hope of determining whether the next large move in the markets is upwards or downwards – likes to the search for the “Golden Fleece.”

Although markets may be efficient in the long-term, in the short-term, financial markets are hostage to fear and greed, as indicated by the “fear gauges”, and these emotions have been on full display. In the last two weeks alone, we have witnessed the Dow Jones Industrial Average (NYSE: DJIA) catapult skyward over +1,200 points, while just a few weeks earlier the Dow cratered about -800 points in a five day period. These are very large trading ranges, and as an investor relying on stock investments solely, then it can be very heart-breaking. If you are more inclined to flow with the market cantankerousness, then option trading is certainly a method to be employed, as long as you are emotionally controlled!

With fresh fears of a European banking collapse, a global recession, and an uncertain election in the U.S. approaching, investors are grasping for clues as the search continues for the “golden fleece” of sentiment indicators to better position their portfolios. Some of these contrarian sentiment indicators can be helpful to your portfolio, if used properly; however interpreting many of the sentiment indicators can be quite difficult and sometimes, about as useful as a screen-door on a submarine.

Contrarianism

Contrarian trading is an investment style that goes against prevailing market trends by buying assets that are performing poorly and then selling when they perform well. Therefore, a contrarian trader is a person who follows this investment style.

A contrarian investor believes that the people who say the market is going up do so only when they are fully invested and have no further purchasing power. At this point, the market is at a peak. On the other hand, when people predict a downturn, they have already sold out, at which point the market can only go up.

Contrarian investors tend to use various sentiment indicators and particularly those that emphasizes out-of-favor securities with low P/E ratios. These types of sentiment indicators are discussed in more detail later in the article.

swimming upstream

Put simply – if you follow the herd, you will be led to the slaughterhouse. Contrarians get excited when an otherwise good company has a sharp, but undeserved drop in share price. They swim against the current, and assume the market is usually wrong at both its extreme lows and highs. The more prices swing, the more misguided they believe the rest of the market to be.

There is a tendency for investors to succumb to short-termism and act on their emotions rather than reason.

The pendulum of investment emotions continually swings back and forth between fear and greed, and many of these sentiment indicators are designed with the goal of capturing emotion extremes.

sentiment pendulum

The concept of mass hysteria is nothing new.

Back in 1841, Charles Mackay published a book entitled, Extraordinary Popular Delusions and the Madness of Crowds, in which Mackay explores the psychology of crowds and mass mania through centuries of history, including the infamous Dutch Tulip Mania of the early 1600s.

Baron Rothschild, an 18th century British nobleman and member of the Rothschild banking family, is credited with saying that "The time to buy is when there's blood in the streets."

He should know. Rothschild made a fortune buying in the panic that followed the Battle of Waterloo against Napoleon. But that's not the whole story. The original quote is believed to be "Buy when there's blood in the streets, even if the blood is your own."

This is contrarian investing at its heart - the strongly-held belief that the worse things seem in the market, the better the opportunities are for profit.

Most people only want winners in their portfolios, but as Warren Buffett warned, "You pay a very high price in the stock market for a cheery consensus." In other words, if everyone agrees with your investment decision, then it's probably not a good one.

Can a Contrarian be Successful?

This question suggests that a contrarian is the exact opposite of a conformist and that is not necessarily a fact.

To be both a conformist and a contrarian at the same time is possible in a sense. The investor might be bullish or with the trend on a long time frame but at the same time may be favoring the bears or the contrarian opinion for a brief period with the longer cycle.

The short answer is yes, but it requires an understanding of three things: that opinion and action are two different things, that trends are where the money is and that price confirmation is needed for any reversal.

Opinion and Action Are Different Things

If you find that your natural tendency is to be a contrarian, you must realize that there can and should be a difference between opinion and action and this leads to a varying of opinions relating to the outcome of sentiment indicators. If the market is rising and you feel it will eventually collapse, you don't need to act on that opinion right now. Opinion can be separated from what is currently going on – this will allow you to profit by trading with the market right now, instead of believing your opinion should be right at this time.

Opinion and emotion can wreak havoc on trading profitability, especially when traders develop very strong opinions or emotions. This is where it becomes imperative to design a trading plan before you start trading. This will allow you to act in a way that is aligned with your trading methods despite opinion or emotion, in other words select your indicators carefully, particularly your sentiment indicators. Trading on opinion can be very costly - the market can be "wrong" a lot longer than a trader can afford to be "right." A trader can design such a trading plan any way they wish, whether by trading with the trend, or watching for high probability reversal points. The key is that contrarians must not act only on opinion - sentiment indicators - but must take other factors such as actual price movement into account.

Trade With the Trend Even if You Don't Believe It

The development of trends is what allows the majority of traders to make money over time. A contrarian can trade in the direction of a trend, even if he or she feels it will reverse at some point. A trend will always reverse simply because prices do not move in one direction forever.

Just because a trader has an opinion about what the market will do, it doesn't mean he or she has to act on it. Trading with the trend will allow the trader to capitalize on market moves while they are occurring instead of always waiting for a reversal. While markets do reverse, trends can last for a long time, even in the face of information that indicates otherwise. Since most individual traders can enter and exit the market with relative ease to due to their position sizes, trading against current price movements does not need to occur.

Traders can make money despite being perpetual contrarians, provided they control their emotions, and the opinions gained from sentiment indicators, and realize that they do not need to act on them. Contrarians can also capitalize on the current trend by trading with it, and should only act on their contrarian opinions when the trend shows signs that it is in jeopardy. After all, if you try to buck the current trend, you could be left with an empty account, even if the market eventually takes the turn you predicted.

sentiment volatility

Putting it On the Line

There are risks to contrarian investing. While the most famous contrarian investors have put big money on the line, swam against the current of common opinion and came out on top, they also did some serious research to ensure that the crowd was indeed wrong and probably studied a great deal of sentiment indicators. So, when a stock takes a nosedive, this doesn't prompt a contrarian investor to put in an immediate buy order, but to find out what has driven the stock down, and whether the drop in price is justified.

Some Contrarian Sentiment Indicators

Sentiment Surveys

The American Association of Individual Investors releases weekly survey results from its membership. With the recent stock market bounce, bullish sentiment has escalated up near historic averages (39.8% bullish), yet the bears still remain skeptical – more than 6% higher than normal (36.4% bearish).

sentiment graph



A different survey, conducted by Investors Intelligence, called the Advisors Sentiment Index, surveys authors of various stock advice newsletters. The index showed bearish sentiment reaching 46.3%, the highest negative reading since the 2008-2009 bear market low. These data can provide some insights, but as you can probably gather, these surveys are also very subjective and often conflicting.

Put-Call Ratio

This is a widely used ratio that measures the trading volume of bearish put options to bullish call options and is used to gauge the overall mood of the market. When investors are fearful and believe prices will go lower, the ratio of puts to calls escalates. At historically high levels (see chart below), this ratio usually indicates a bottoming process in the market.

Volatility Index 

The VIX indicator or “Fear Gauge” calculates inputs from various call and put options to create an approximation of the S&P 500 index implied volatility for the next 30 days. Put simply, when fear is high, the price of insurance catapults upwards and the VIX moves higher. Over the last 25 years a VIX reading of 44 or higher has only been reached nine times so stated, so as you can see from the chart below, the recent market rally has coincided with the short-term peak in the VIX.

sentiment-put/call/vix



Strategist Sentiment Indicators

If you’re looking for a contrarian call to payoff, don’t hold your breath by waiting for bearish strategist sentiment to kick-in. Barry Ritholtz at the Big Picture got it right when he summarized Barron’s bullish strategist outlook by saying, “File this one under Duh!” Like most Wall Street and asset management firms, strategists have an inherent conflict of interest to provide a rosy outlook.

Short Interest

The higher the amount of shares shorted, the larger the pent-up demand to buy shares becomes in the future. Extremely high levels of short interest tend to coincide with price bottoms because as prices begin to move higher, holders of short positions often feel “squeezed” to buy shares and push prices higher. According to SmartMoney.com, hedge fund managers own the lowest percentage of stocks (45%) since March 2009 market price bottom. Research from Data Explorer also suggests that sentiment is severely negative – the highest short interest level experienced since mid-2009.

fund flow

Fund Flow Data

The direction of investment dollars flowing in and out of mutual funds can provide some perspective on the psychology of the masses. Recent data coming from the Investment Company Institute shows that -$63.6 billion has flowed out of all equity funds in 2011, while +$81.7 billion has flowed into bond funds. Suffice it to say, investor nervousness has made stocks as about as popular as the approval ratings of Congress.

Your Reaction

When it comes to sentiment indicators, I believe actions speak much louder than words. Indicators based on opinions, surveys, and technical analysis data can be very subjective, therefore concentration should be centered on those indicators explaining actual measurable investor behavior (i.e., Put-Call, VIX, Short Interest, Fund Flow, and other action-oriented trading metrics).

news avalanche

As we know from filtering through the avalanche of daily news data, the world can obviously become a much worse place (i.e., Greece, eurozone collapse, double-dip, inflation, banking collapse, muni defaults, widening CDS spreads, etc,). If you believe the world is on the cusp of ending and/or you do not believe investors are sufficiently bearish, I encourage you to build your bunker stuffed with gold, and/or join the nearest local Occupy Wall Street chapter.

If, however, you are looking to sharpen the returns on your portfolio and are thirsty for some emotional answers, pour yourself a cup of tea, sit in your favorite armchair and pore over some sentiment indicators, or, if you don’t want to study the market movement indicators but still wish to profit, become a member of S.O.M.E. (Stock Options Made Easy) and let us do the hard work for you.

Contrarians let the market bring the deals to them, rather than chasing after them.


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