In the last issue, we covered why a sentiment indicator should work. Now it’s time to look at a practical application.
In sentiment indicators, the history being repeated is the unchanging nature of human emotion. Greed and fear drive the markets and they are measurable to some degree. A widely available is the American Association of Individual Investors (AAII) Sentiment Survey. This is a survey of individual investors which answers the question of how they feel about the market each week. Data from 1987 is available at http://www.aaii.com/files/surveys/sentiment.xls. A small part of the survey results from 2000 is shown below.
| DATE | % BULLS | S&P 500 CLOSE |
| 1-6-00 | 75.0% | 1,441.47 |
| 1-13-00 | 59.3% | 1,465.15 |
| 1-20-00 | 57.1% | 1,441.36 |
| 1-27-00 | 53.7% | 1,360.16 |
| 2-3-00 | 51.1% | 1,424.37 |
| 2-10-00 | 41.9% | 1,387.12 |
| 2-17-00 | 27.3% | 1,346.09 |
| 2-24-00 | 41.4% | 1,333.36 |
| 3-2-00 | 36.7% | 1,409.17 |
| 3-8-00 | 58.3% | 1,395.07 |
| 3-16-00 | 50.0% | 1,464.47 |
| 3-23-00 | 65.7% | 1,527.46 |
| 3-30-00 | 38.9% | 1,498.58 |
| 4-6-00 | 45.8% | 1,516.35 |
| 4-13-00 | 51.9% | 1,356.56 |
| 4-20-00 | 63.7% | 1,434.54 |
| 4-27-00 | 61.3% | 1,452.43 |
As the stock market was peaking, there was preparing for its final leg higher, the bears outnumbered the bulls in February 2000. At the high, the majority was decidedly bullish, and they maintained their optimism as the decline began. The individual investor still seems to believe that the bigger fool identified by Keynes was just around the corner.
We see the opposite pattern in October 2002 as most individuals are bearish at the bottom. There was general despair and investors acted as if only a fool would be buying at that time. Similar behavior is observed at other tops and bottoms. At key turning points, the crowd will usually hold the wrong opinion.
Margin debt levels can also be used to monitor sentiment. Traders are likely to make market bets when they’re bullish and that would lead to an increase in margin debt balances. When traders are most bullish, the market may be at a peak.
Sentiment indicators are not always contrarian – a contrarian indicator is one that prompts you to take action against the popular opinion. Insider trading activity measures the sentiment of corporate insiders, theoretically the best informed investors, and they will usually be on the right side of the market.
Technical analysis offers valuable insights into the mid of the client. Sentiment data can show the general attitude of investors, and it is often best to begin a conversation with an understanding of how they perceive the markets rather than explaining how markets actually work. The professional can easily work these tools into client presentations, and could even use them to help convert prospects to clients.
Michael Carr, CMT, is a member of the Market Technicians Association, and editor of the MTA's newsletter, Technically Speaking. He has served as a director of the MTA Educational Foundation, promoting the value of technical analysis to the academic community. He is the author of two investment books, Smarter Investing in Any Economy: The Definitive Guide to Relative Strength Investing (W&A Publishing, 2008), and Conquering the Divide: How to Use Economic Indicators to Catch Stock Market Trends (W&A Publishing, 2011).
