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 missteps often help them profit. It’s a basic premise of behavioral finance, that folks behave irrationally when it comes to their investments. People are panicking like the world is coming to an end? Time to buy. Your cabbie is giving you stock tips during a raging bull run? Time to sell.
Enter the investor sentiment reading. A few key metrics – like the American Association of Individual Investors Index, the Consensus Index, and Market Vane – track what you and I 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 darn glum. The AAII index is currently at 30.5 percent bulls, virtually unchanged from the week before. Once it’s below 30 percent, Springer starts getting an itchy trigger finger to buy equities. Spurred by Thursday’s massive selloff, 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 20 percent? 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 tipoff that investors are feeling overly doomed or elated.
Realize their limitations:
The AAII reading isn’t a truly scientific result, in that it’s a voluntary member survey. “While the organization 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.“Sometimes the readings are not all the same,” says Paul Azzopardi, the Toronto-based author of Behavioral 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 realize 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 25 percent bulls after this particularly bumpy week. “But it could suggest that we’re within range of a sizable rally.”
