Trying To Solve The Sentiment Conundrum

Jul. 03, 2017 4:37 PM ETSPY, QQQ, DIA, SH, IWM, TZA, SSO, TNA, VOO, SDS, IVV, SPXU, TQQQ, UPRO, PSQ, SPXL, UWM, RSP, SPXS, SQQQ, QID, DOG, QLD, CRF, DXD, UDOW, RWL-OLD, SDOW, VFINX, URTY, EPS, TWM, SCHX, VV, RWM, DDM, SRTY, VTWO, QQEW, QQQE, FEX, ILCB, SPLX, EEH, EQL, SFLA-OLD, SPSM, QQXT, SPUU, IWL, FWDD, SYE, SBUS, SMLL, SPXE, PPLC, PPSC, UDPIX, JHML, OTPIX, RYARX, SPXN, USSD, HUSV, RYRSX, SCAP, SPDN, SPXT, SPXV, USWD7 Comments

Steven Saville

1.6K Followers

Editor's note: Originally published at tsi-blog.com on July 3, 2017

[This post is a modified excerpt from a recent TSI commentary]

In a 12th June blog post, I revisited the potential pitfalls in using sentiment as a market timing tool. As an example of a pitfall, the post included a chart of the Investors Intelligence (II) bull/bear ratio suggesting that US stock market sentiment had been consistent with a bull-market top for the bulk of the past four years. Even though the chart helped to make my point, it is appropriate to question how sentiment, when used as a contrary indicator, could be so wrong for so long.

I've come up with a possible explanation for why measures of US stock market sentiment that worked well as contrary indicators in the past have not been useful of late. The reason relates to the third of the potential pitfalls outlined in the above-linked blog post. Specifically:

"… regardless of what sentiment surveys say, there will always be a lot of bears and a lot of bulls in any financial market. It must be this way otherwise there would be no trading and the market would cease to function. As a consequence, if a survey shows that almost all traders are bullish or that almost all traders are bearish then the survey must be dealing with only a small - and possibly not representative - segment of the overall market."

The explanation I've come up with is that prior to the past few years, the II sentiment survey, which is a survey of investment advisors who regularly publish their views via newsletters, reflected the sentiment of the investing public, but this is not so much the case anymore. Prior to the past few years, the advisors and the general public would become increasingly bullish or increasingly bearish together, with high levels of optimism invariably following persistent price strength and high levels of pessimism invariably following either persistent or dramatic price weakness.

Over the past few years, however, the perceptions of these two groups took separate paths. Investment advisors became very optimistic in reaction to the strong upward trend in prices, but for the most part, the general public remained unenthusiastic about the stock market.

The change described above can be illustrated by comparing the II bullish percentage with the AAII (American Association of Individual Investors) bullish percentage, which has been done on the chart displayed below. The AAII survey is based on the opinions of retail investors, that is, the general public.

The chart shows that prior to 2014, the II (the blue line) and AAII (the black line) bullish percentages typically moved up and down together within a similar range, but that from 2014 onward, the II bullish percentage tended to be significantly higher. Furthermore, the distance between the two survey results has increased since early this year, with the II bullish percentage remaining above 50 and the AAII bullish percentage spending most of its time in the 25-35 range. The most recent results show an II bullish percent of 54.9 and an AAII bullish percent of 29.7.

It seems that the general public's stock market sentiment has not reached an optimistic extreme during the current cycle. Does this mean that there's a lot more price strength to come or does it mean that the next major price top will happen without the general public having fully embraced the upward trend?

I don't know, but it's definitely possible that the public will never fully embrace the latest bullish trend for the simple reason that it is financially incapable of doing so. Having had its savings decimated when earlier Fed-fueled investment booms inevitably collapsed, it may not have the financial wherewithal to enthusiastically participate in the Fed's latest bubble-blowing venture.

This article was written by

Steven Saville

1.6K Followers

I graduated from the University of Western Australia in 1984 with a degree in electronic engineering and from 1984 until 1998 worked in the commercial construction industry as an engineer, a project manager and an operations manager. I began investing in the stock market 2 months prior to the 1987 stock market crash and thus quickly learned about the downside potential of stocks. Only slightly daunted by the rather inauspicious timing of my entry into the world of financial market investments, my interest in the stock market grew steadily over the years. In 1993, after studying the history of money, the nature of our present-day fiat monetary system and the role of banks in the creation of money, I developed an interest in gold. Another very important lesson soon followed: gold may be the ideal form of money for those who believe in free markets and a wonderful hedge against the inherent instability of the government-imposed paper currencies, but it is not always a good investment. By mid-1998 the time and money involved in my financial market research/investments had grown to the point where I was forced to make a decision: scale back on my involvement in the financial world or give up my day job. The decision was actually quite an easy one to make and so, at the beginning of 1999, I began investing/trading on a full-time basis. My major concern in deciding to pursue a career in which I devoted all of my time to my own investments was that I would miss the personal interaction that had been part and parcel of my business management career. The Speculative Investor (TSI) web site was launched in August of 1999 as a means for me to interact with the world by making my analysis/ideas available on the Internet and inviting feedback from others with similar interests. During its first 14 months of operation the TSI web site was free of charge, but due to the site's growing popularity I changed it to a subscription-based service in October of 2000. Its popularity continued to grow, although I remained -- and remain to this day -- a professional speculator who happens to write a newsletter as opposed to someone whose overriding focus is selling newsletter subscriptions. My approach is 'top down'; specifically, I first ascertain overall market trends and then use a combination of fundamental and technical analysis to find individual stocks that stand to benefit from these broad trends. This approach is based on my experience that it's an order of magnitude easier to pick a winning stock from within a market or market sector that's immersed in a long-term bullish trend than to do so against the backdrop of a bearish overall market trend. Fortunately, there's always a bull market somewhere. I've lived in Asia (Hong Kong, China and Malaysia) since 1995 and currently reside in Malaysian Borneo.

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