Stirring the Sentiment Tea Leaves Redux

July 24, 2017 at 12:10 pm Leave a comment

Despite the Volatility Index (VIX) currently operating at the low end of historical ranges (9.36), the equity markets operate on a perpetual volatility rollercoaster. This period of relative calm has not stopped participants from searching for the Holy Grail of indicators in hopes of determining whether the next large move in the markets is upwards or downwards. Although markets may be efficient in the long-run (see Crisis Black Eye), in the short-run, financial markets are hostage to fear and greed, and these emotions have been on full display. Although the Dow Jones Industrial Average has almost catapulted almost +4,000 points since the period right before the 2016 Presidential Election, last June also produced a roughly -1,000 point decline in the Dow. With fresh fears over Russian intervention-collusion, global monetary policy uncertainty, and political risk in North Korea, investors are grasping for clues as they read the indicator tea leaves to better position their portfolios. Some of these contrarian sentiment indicators can be helpful to your portfolio, if used properly. However, in large part, interpreting many of the sentiment indicators is as useful as reading tea leaves for your winning lotto number picks.

The Art of Tea Leave Reading

The premise behind contrarian investing is fairly simple – if you follow the herd, you will be led to the slaughterhouse. 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 indicators are designed with the goal of capturing emotion extremes.

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 (see Soros Super Bubble).

Out of sympathy for your eyeballs, I will not conduct an in-depth review of all the contrarian indicators, but here is brief sampling:

Sentiment Surveys: The American Association of Individual Investors (AAII) releases weekly survey results from its membership. A different survey, conducted by Investors Intelligence, called the Advisors Sentiment Index, surveys authors of various stock advice newsletters. 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 (VIX): 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.

Strategist Sentiment: If you’re looking for a contrarian call to payoff, I wouldn’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. More often than not, strategists’ opinions move like the wind in whatever direction stocks are currently moving.

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.

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. This data can be found at the Investment Company Institute (ICI). Given the bloodletting of the 2008-2009 financial crisis, investors skepticism has made stocks about as popular as the approval ratings of Congress.

When it comes to sentiment indicators, I believe actions speak much louder than words. To the extent I actually do track some of these indicators, I pay much less attention to those indicators based on opinions, surveys, and technical analysis data (see Astrology or Lob Wedge). Most of my concentration is centered on those indicators explaining actual measurable investor behavior (i.e., Put-Call, VIX, Short Interest, Fund Flow, and other action-oriented trading metrics).

As we know from filtering through the avalanche of daily news data, the world can obviously can be a scary place (see Head Fakes Surprise). 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 own personal bunker and stuff it with gold or Bitcoin. 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 and pore over some sentiment indicators.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

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