Learn to master sentiment readings and you may just make some money
Published 29/09/2011 | 05:00
DON'T take this the wrong way, but everything you're thinking and feeling about the stock market is usually dead wrong. And money managers appreciate that. Your mis-steps often help them profit.
It's a basic premise of behavioural finance, that people behave irrationally when it comes to their investments.
People are panicking like the world is coming to an end? Time to buy. Your taxi driver is giving you stock tips during a raging bull run? Time to sell.
This is not easy in Ireland where we have so few indices of investor sentiment but America has many useful ways of tracking investor sentiment.
A few key metrics -- like the American Association of Individual Investors Index, the Consensus Index, and Market Vane -- track what Americans are feeling about the stock market, and convert it into numbers. For true contrarians, the findings are just as telling as more fundamental metrics like price/earnings or free cash flow.
For example, if Mom and Pop investors are overly bullish or bearish, then it's a flashing billboard to go the other way.
"It's the perfect contrary indicator, and has been for a long time," says Keith Springer, president of Springer Financial Advisors in Sacramento, California, and author of 'Facing Goliath: How to Triumph in the Dangerous Market Ahead'.
"The public is always wrong. They always act on emotion -- to buy when they feel the best, to sell when they feel the worst," he says.
And right now, they're feeling pretty glum. The AAII index is currently at 30.5pc bulls, virtually unchanged from the week before. Once it's below 30pc, Springer starts getting an itchy trigger finger to buy equities.
Spurred by last Thursday's massive sell-off, with the Dow dropping a few hundred points to well below 11,000, we could see those numbers dip even further. And if it craters below 20pc? A "screaming buy", Springer says.
Sentiment readings aren't that radical a concept. In fact, they can trace their lineage to the original value investor, Ben Graham, who famously held that Mr Market is a fickle and irrational beast.
He quotes different stock prices virtually every second, based on the whims of the moment, and smart investors can examine company fundamentals to identify seriously mispriced equities.
Nevertheless, many market watchers don't even know what the AAII number even is. "I love the fact that nobody ever talks about it," says Springer. "Because if everyone followed it, then it would become worthless."
Of course, investor sentiment isn't exactly a slam-dunk metric. If it were, then everyone would be filthy rich already. Tread especially carefully if speculating in embattled individual stocks.
Sentiment readings won't be of much help if -- as with BNP Paribas, say -- you're stepping in front of a speeding train. That said, a few pointers for leveraging investor sentiment to your best advantage:
•Look for longer-term trends.
A one-week blip, of an unusually high bullish or bearish numbers, shouldn't be enough to start moving money.
Once you're hitting three or four weeks of persistent numbers, that's the real tip-off that investors are feeling overly doomed or elated.
The AAII reading isn't a truly scientific result, in that it's a voluntary member survey. "While the organisation has 150,000 members, we understand that only several hundred regularly participate," stock-market research firm Birinyi Associates points out in a recent research note.
As the product of a self-selecting process (like political exit polls), the data is useful for understanding broad-strokes trends but shouldn't be taken as absolute gospel.
•Weigh readings from multiple sources.
Since survey samples can be relatively small, it's possible a particular metric could get a one-week reading that's out of line with popular sentiment.
For a better bird's-eye view, scour a variety of polls (check out a handful of the most prominent ones here). "Sometimes the readings are not all the same," says Paul Azzopardi, the Toronto-based author of 'Behavioural Technical Analysis'. "You're looking for extreme values from multiple indicators, because after that, sentiment usually changes -- and the market changes along with it."
•Don't expect immediate results.
If you buy after a period of extreme bearishness, and don't realise quick profits, don't despair. This is a longer-term tool, not something for the day-trading set.
"The stock market doesn't turn on a dime," says Springer, who expects the AAII number might dip to 2pc bulls after this particularly bumpy week. "But it could suggest that we're within range of a sizable rally."