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Thursday, 29 April 2010

Sentiment Is Contrarian, Not So Reliable

Acting on feelings might seem like wisdom in romantic comedies, but it's a lousy way to make investment decisions.

In fact, it's such a crummy way to invest that some sentiment indicators work in a contrarian fashion. In other words, when the market seems to be telling you how much it loves stocks, it's time to grab your wallet and run.

The problem with sentiment indicators is that they're inconsistent. IBD lists several on the How's The Market? page, today on Page B2.

They are best used as a confirmation of your primary guide. Your primary guide is the price and volume action of the major indexes, along with the action of top-rated stocks.

Here are a few contrarian indicators you can find on the How's The Market? page:

• Bulls vs. Bears: This contrarian indicator from Investors Intelligence measures bullishness and bearishness among investment advisers. When the bullish percentage is 20 percentage points greater than the bearish percentage, that is considered a warning. When it hits 35 or 40 points in the bulls' favor, it is considered dangerous.

It hit 42.6 at the market's October 2007 high, on the eve of a bear market. It was 37.5 in mid-January, just before a 9.7% decline in the Nasdaq. It's also had false signals (see chart).

The most useful signal, though, is when there are more bears than bulls. That often has worked as a bottoming signal.

• NYSE Short Interest Ratio: This contrarian metric involves dividing monthly short interest on the exchange by the average daily volume. The result is how many days of average trade it would take to cover all the shorts.

When the ratio is at a five-year high, it indicates that traders are bearish. According to contrarians, this means the market is about to rise. When the ratio is at a five-year low, it says traders are bullish, which means the market might top.

In mid-March 2000, the ratio was at a five-year low, pointing to bullishness. This was just before the start of a nasty bear market. So in this case, the ratio worked.

But in late September 2007 to mid-October, the ratio marked five-years highs. This suggested that traders were bearish. By contrarian theory, that meant the indexes were about to rise. But a couple of weeks later, the bear market began.

When short interest is elevated, market gains force shorts to buy to cover their positions. Once that starts happening, there's fuel for more market gains.

Some say arbitrage transactions distort the short interest ratio and make it unreliable as an indicator.

• Puts vs. Calls Volume: A ratio of 1.0 and up is considered a sign that the market is about to rise. This tool picked the short-term lows on Nov. 27, Feb. 4-5 and Feb. 23. But it was too early on Jan. 22.

Other indicators are subjective. Many brokers and market watchers find contrarian feedback in the views of ordinary people.

For example, as the market rose in the months after the follow-through in March 2009, many ordinary people were either convinced that the market was still doing terribly, or didn't trust the rebound.

Deeper in a bull market, people at social gatherings will fish for advice from brokers and market watchers. Later, they'll try to give advice.

And late in a bull market, you run into people who say they're thinking of quitting their day job and investing full time. When you hear that, the run is about done.

Legendary investor John Templeton described the cycle this way: "Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria."

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