Investing Caffeine

Sentiment Indicators: Reading the Tea Leaves

October 22, 2010 at 1:53 am 1 comment

Market commentators and TV pundits are constantly debating whether the market is overbought or oversold. Quantitative measures, often based on valuation measures, are used to support either case. But the debate doesn’t stop there. As a backup, reading the emotional tea leaves of investor attitudes is relied upon as a fortune telling stock market ritual (see alsoTechnical Analysis article). Generally these tools are used on a contrarian basis when deciding about purchase or sale timing. The train of thought follows excessive optimism is tied to being fully invested, therefore the belief is only one future direction left…down. The thought process is also believed to work in reverse.

Actions Louder Than Words

When it comes to investing, I believe actions speak louder than words. For example, words answered in a subjective survey mean much less to me in gauging optimism or pessimism than what investors are really doing with their cool, hard cash. Asset flow data indicates where money is in fact going. Currently the vast majority of money is going into bonds, meaning the public hates stocks. That’s fine, because without pessimism, there would be fewer opportunities.

Most sentiment indicators are an unscientific cobbling of mood surveys designed to check the pulse of investors. How is the data used? As mentioned above, the sentiment indicators are commonly used as a contrarian tool…meaning: sell the market when the mood is hot and buy the market when it is cold.

Here are some of the more popular sentiment indicators:

1)      Sentiment Surveys (AAII/NAAIM/Advisors): Each measures different bullish/bearish opinions regarding the stock market.

2)      CBOE Volatility Index (VIX): The “fear gauge” developed using implied option volatility (read also VIX article).

3)      Breadth Indicators (including Advanced-Decline and High-Low Ratios): Measures the number of up stocks vs. down stocks. Used as measurement device to identify extreme points in a market cycle.

4)      NYSE Bullish Percentage: Calculates the percentage of bullish stock price patterns and used as a contrarian indicator.

5)      NYSE 50-Day and 200-Day Moving Average: Another technical price indicator that is used to determine overbought and oversold price conditions.

6)      Put/Call Ratio: The number of puts purchased relative to calls is used by some to measure the relative optimism/pessimism of investors.

7)      Volume Spikes: Optimistic or pessimistic traders will transact more shares, therefore sentiment can be gauged by tracking volume metrics versus historical averages.

Sentiment Shortcomings

From a ten thousand foot level, the contrarian premise of sentiment indicators makes sense, if you believe as Warren Buffett does that it is beneficial to buy fear and sell greed. However, many of these indicators are more akin to reading tea leaves, than utilizing a scientific tool. Investors enjoy black and white simplicity, but regrettably the world and the stock market come in many shades of gray. Even if you believe mood can be accurately measured, that doesn’t account for the ever-changing state of human temperament. For instance, in a restaurant setting, my wife will change her menu choice four times before the waiter/waitress takes her order. Investor sentiment can be just as fickle depending on the Dubai, Greece, Swine Flu, or foreclosure headline du jour.

Other major problems with these indicators are time horizon and degree of imbalance. Yeah, an index or stock may be oversold, but by how much and over what timeframe? Perhaps a security is oversold on an intraday chart, but dramatically overbought on a monthly basis? Then what?

The sentiment indicators can also become distorted by a changing survey population. Average investors have fled the equity markets and have followed the pied piper Bill Gross to fixed income nirvana. What we have left are a lot of unstable high frequency traders who often change opinions in a matter of seconds. These loose hands are likely to warp the sentiment indicator results.

Strange Breed

Investors are strange and unique animals that continually react to economic noise and emotional headlines in the financial markets. Despite the infinitely complex world we live in, people and investors use everything available at their disposal in an attempt to make sense of our endlessly random financial markets. One day interest rate declines are said to be the cause of market declines because of interest rate concerns. The next day, interest rate declines due to “quantitative easing” comments by Federal Reserve Chairman Ben Bernanke are attributed to the rise in stock prices. So, which one is it? Are rate declines positive or negative for the market?

On a daily basis, the media outlets are arrogant enough to act like they have all the answers to any price movement, rather than chalking up the true reason to random market volatility, sensationalistic noise, or simply more sellers than buyers. Virtually any news event will be handicapped for its market impact. If Ben Bernanke farts, people want to know what he ate and what impact it will have on Fed policy.

Sentiment indicators are some of the many tools used by professionals and non-professionals alike. While these indicators pose some usefulness, overreliance on reading these sentiment tea leaves could prove hazardous to your fortune telling future.

Wade W. Slome, CFA, CFP®  

Entry filed under: Education, Trading. Tags: AAII, sentiment indicators, technical analysis, time horizon, Trading.