Written December 8th 2010
The Psychology Of Investing (Part 1)
Successful investing is about far more than understanding value, balance sheets and quality of management. One also needs to be a pretty good amateur psychologist. Virtually all market tops and bottoms occur at emotional extremes: Bottoms coincide with widespread panic while Tops tend to be associated with some unjustified level of overconfidence or greed.The theory behind sentiment analysis is quite simple, and so logical that Mr. Spock himself would not even raise an eyebrow. Market peaks occur when buying power has become exhausted. This happens because those buyers have become either complacent, overconfident or just plain greedy. Once they’ve all bought in, who’s left to buy?
Market Sentiment Polls
This level of emotional extreme can be measured quantitatively, so one need not be an empath to get a good fix on things. The most basic form of sentiment reading is the market poll. There are several which have long track records, are consistently applied and easily accessible for historical analysis. The two of note are Investor’s Intelligence (https://www.investorsintelligence.com/) which polls newsletter writers and the American Association of Individual Investors (AAII) (https://www.AAII.org) which polls retail investors. Edward Yardeni of Yardeni Research https://www.yardeni.com/pub/peacockbullbear.pdf has done some very good statistical analysis of the polls versus future market direction.
The AAII poll currently shows 36% bulls versus 31% bears a rather neutral number. However, the Investors Intelligence readings for October 2 show 62% BULLS and 18% BEARS. This is among the highest Bull to Bear ratio and is as clear a sign of danger as this indicator can flash.. By comparison, the 2000 and 2007 peaks were characterized by 55-60% percent BEARS and 20-30% BEARS.
The Always Bullish Wall Street Firms
CNBC recently released the year end 2018 projections for 19 Wall Street Firms. Of the 19, 16 saw higher prices than Friday’s close of 2885. In fact, only 3 firms, Morgan Stanley, Goldman Sachs, and Citigroup saw year end targets lower, but by an average 0f 3%. The top target was 3200 and the bulk of the other lemmings came in at exactly 3000. The great thing about agreeing with everyone is that you don’t lose your job, no matter what. If everyone is wrong. And they will, no heads will roll. Until of course, someone shows up with Markonomics101.com.
There is also the “Magazine Cover” indicator. Mainstream publications like Business Week, Time and Newsweek are famous for having cover stories about the “Death Of Equities” or the “New Age of Investing” almost exactly at market peaks and bottoms. These publications act as investor polls in and of themselves, merely reflecting what their readers believe.
Another excellent sentiment reading, and probably the best one of all, is the level of market volatility. This one may be best because it’s determined through actual trading. Volatility is a statistical measure of the expected degree of variability in stock prices over various subsets of time. It is a key component in options pricing, but very, very useful in understanding exactly where investors sentiments lie.
There are several measure of volatility, but the best one is called the VIX, which is its symbol. At market bottoms, the VIX will have readings of above 50. Literally translated, this means that investors have priced in a range of up or down 50% over the coming year. At the other end, VIX can print under 10%, indicating complete complacency or lack of fear.
You will note that VIX is currently incredibly low, near 10% suggesting a low risk environment. How silly. It confirms the very ominous readings mentioned above in the investor sentiment polls.
Think this is all there is to sentiment? Not even close! In Part 2 we’ll discuss other very interesting indicators of how investors deploy capital and how it gives us pundits a means of understanding what’s in their heads.
Sunday, December 12, 2010
The Psychology Of Investing (Part 2)
Making money requires some degree of timing. While investment legends such as Warren Buffett and Benjamin Graham completely avoid market timing, they would not disagree that there are far better times to enter a position and exit a position than others.
Entering a new position when there is panic is a far better bet than when shoe-shine boys and taxicab drivers are giving stock tips. So, we turn again to different ways to measure investment sentiment.
Another set of indicators employs options buying and selling statistics. Put options buyers bet on falling prices while call option buyers bet on rising prices. Therefore the “put/call ratio” tracks bearish versus bullish bets and acts as a contrary indicator. These ratios can also be found in Shaeffer’s Investment Research by clicking here: (https://www.schaeffersresearch.com/content/-in-category/categories/most-active-weekly-options)
Probably the most comprehensive sentiment analyst is a guy named Jason Goepfert who has a newsletter known as Sentiment Trader (https://sentimentrader.com/models/) .
Jason constucts several models of investor emotion. His composite index is constructed using the following indicators: Sentiment surveys, proprietary versions of the positioning of Futures traders, puts/calls, volatility indices, breadth ratios, the “Trading Index” or TRIN, and several un-published indicators.
He also measures the positioning of “smart” to “dumb” money, or those folks who have a tendency to be consistently right versus those consistently wrong. One example of “smart money” would be corporate insiders who are in the best position of knowing how their companies are doing. When corporate insiders buy their own stock, that is about a good of an endorsement of a company’s prospects as you can get. Dumb money is your typical retail investor and option speculator, who tend to be wrong far more often than right.
Taking everything together, virtually any reasonably calculated sentiment measure is suggesting that market confidence is at unsustainable levels. Most measures are within striking distance or exceeding the type of euphoria which characterized the major tops in 2000 and 2007.
Marc Hulbert tracks sentiment in the Precious Metals Arena
Gold has certainly lost its appeal and luster of late, but it may be on the exact opposite side of the equity players. Who’s left to sell? Gold is possibly bottoming out here and the very poor sentiment suggests the sellers have pretty much sold their holdings. Sounds like the making of a GOLDEN Time to buy to me, and we’ll be watching for signs of the long, long, long, long, awaited rally. Gold has lasted for 5000 years, more than any fiat currency and before long, it will have its day too. Even if a little later than expected.
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This updated version has been edited to present current data. The concepts first written in 2010 remain the same.