The efficient market hypothesis states that the financial markets are “efficient,” meaning that they should already fully incorporate all available information. However, it is also true that the stock market generally goes through periods of being undersold and overbought. How can we explain this phenomenon? One possibility is investor emotions.
Although investors would like to imagine that their decisions are rational, most have bought at near-highs due to fear of losing out on gains and sold at near-lows due to fear of further losses. This herd behavior is called market sentiment; when market sentiment is low, the majority believes the market will fall, while high market sentiment means that the majority feels the market will rise in value. However, more often than not, the market will move against the sentiment of the majority. Therefore, many professional money managers use market sentiment as a contrarian indicator, buying when sentiment is pessimistic and selling when sentiment is optimistic.
Several websites provide indicators of investor sentiment.
The CBOE Volatility Index (VIX), otherwise known as the fear gauge, is calculated and disseminated in real-time by the Chicago Board Options Exchange. The figure is derived as a weighted blend of prices for a range of options on the S&P 500. Options pricing tends to increase when more volatility is present; therefore, VIX will jump when there is more volatility, or expectation of volatility, in the market. Current VIX data can be found on many financial websites, such as Yahoo! Finance (Figure 1). For more in-depth data, go to www.cboe.com/micro/VIX.
Investors often use this as a gauge for market peaks and bottoms. As you can see in Figure 1, VIX does hold some predictive power for market peaks and valleys.
See the Technically Speaking column in the Third Quarter 2010 issue of CI for more on the VIX.
The put-call ratio is calculated by taking the ratio of the trading volume of puts over the trading volume of calls. Investors purchase puts to protect themselves from a market downturn and purchase calls to possibly gain from a market rally. Therefore, a large number of puts, when compared to calls, indicates low investor sentiment. The easiest way to locate the put-call ratio is to visit www.cboe.com/data/mktstat.aspx (Figure 2).
A total put-call ratio above one means more investors are looking to protect on the downside rather than possibly gaining on the upside. This can signal a market bottom. The higher the ratio goes, the more pessimistic investor sentiment is. As the ratio drops, investors may become complacent, or overly optimistic, in the stock market.
See the Fourth Quarter 2010 CI Technically Speaking column for more on the put-call ratio.
Cash coming into and going out of mutual funds is measured by mutual fund money flow. Contrarian investors often look at this data to try to examine which way the “dumb money” is flowing.
The Investment Company Institute publishes a chart of the estimated long-term mutual fund flows, which is updated on a weekly basis. As shown in Figure 3, as of November 16, 2011, the past five weeks have all seen negative cash flows from long-term mutual funds. From a contrarian standpoint, this is interpreted as a bullish indicator. In addition, you can see that cash is flowing into bond funds, specifically municipal funds.
AAII’s Sentiment Survey is published weekly and can be found at www.aaii.com/sentimentsurvey. It measures the percentage of individuals who are bullish, bearish and neutral about the stock market over the next six months (Figure 4).
The survey is open to AAII members and is taken voluntarily. The average AAII member is male, around 60 years of age, and has a graduate degree. The survey is unique in that it represents the upper echelon of active, “hands-on” investors. The survey respondents tend to be individual investors, nearing retirement, and those having a substantial portfolio. Over the years, this contrarian indicator has proven to be surprisingly accurate.
As shown in Figure 4, for the week ending November 23, 2011, the percentage of respondents who are bearish is currently higher than the survey’s long-term bearish average. This may indicate that we are nearing a market bottom.
Margin debt is an indicator that can be reasonably argued as useful by opposing investors: Although many believe margin debt to be a contrarian indicator, others take it at face value. Margin debt is a measure of how much investors are buying on margin. Generally speaking, using margins is much riskier than buying with available cash, as any small loss can force investors to close out positions and cover margins. Many investors believe more “smart money” uses margin, and that these investors may be privy to more information or data than available to average individual investors. As you can see from the chart we created on Bloomberg.com, the long-term trend seems to show that this reasoning may be correct.
However, the argument that more investors will use margin when they believe the market will rally is also sound. Using the same chart, you can see that although the long-term trend shows that an increase in margin debt means a gain in stock price, short-term trends seem to indicate the opposite.