Sentiment describes the opinions, emotions or views of a group of people. In investing, sentiment can be a powerful determinant of security prices, especially in the short run. Here, emotions—whether rational or irrational—can drive prices. For individual securities, the price is the sum total of the sentiment of all market participants. If you could forecast changes in sentiment, then you should have an advantage in determining changes in the market. The problem with sentiment is that it’s really only known after-the-fact.
Market sentiment—the summation of all market expectations—often directly reflects where the market has been, not where it is going. When market sentiment is low, this means that the majority believes the market will fall, while high market sentiment means that the majority feels the market will rise in value. However, history shows us that more times than not the market will go against the majority. Extremely bullish levels of sentiment often come after strong market run-ups when investors are fully invested in the market. Even if they are bullish about the future, they have limited additional resources to invest. By following market sentiment indicators, you may be able to pick out market tops and bottoms.
There are different ways in which you can measure market sentiment—through surveys of individual and professional investors, examination of trading data such as block trades and short interest, or even looking at the cover stories of major publications. In this article, we examine several popular market sentiment indicators and discuss how they are normally interpreted and used in forecasting market levels.
Several surveys of investor sentiment are available today. Some of the more popular are the AAII Sentiment Survey, the Consensus Index from Consensus, Inc., Investors Intelligence, Hulbert Financial Digest’s Newsletter Sentiment, and Market Vane. All except for the Hulbert market gauge are carried weekly in Barron’s under Investor Sentiment Readings in the Market Week section (Figure 1).
AAII Sentiment Survey: This survey measures the percentage of individual investors who are bullish, bearish, and neutral on the stock market over the next six months (Figure 2). Originally started in 1987 as a weekly survey sent out via mail to a random sample of AAII members, the survey has been conducted on-line since 2000. Members of AAII can vote once a week at the AAII Web site (www.aaii.com). Results of the survey are compiled on a weekly basis (Thursdays) at the AAII Web site and are published weekly in Barron’s.
Hulbert’s Newsletter Sentiment: Mark Hulbert, publisher of the Hulbert Financial Digest, derives newsletter writers’ opinions on market direction based on their suggested asset allocations and the amount invested in the market. This data is available in the monthly newsletter, which rates the performance of advisory newsletters. Look for the section titled “Market Exposure Among Market Timers.” The newsletter is also accessible at the Hulbert Financial Digest Web site (www.hulbertdigest.com).
Consensus Index of Bullish Market Opinion: This index measures the attitudes and positions of all analysts, brokers, and investment managers surveyed by Consensus, Inc. The results of this survey are published in Barron’s and can be found at the Consensus, Inc. Web site (www.consensus-inc.com).
Investors Intelligence: Investors Intelligence is a newsletter published by Chartcraft (www.chartcraft.com) that polls investment advisors and classifies them as being a bear, bull, or correction. The survey’s correction number represents those advisors who are, for the most part, bullish but believe there will be some short-term weakness in the market. The results of this survey are published weekly in Barron’s.
Market Vane: The Bullish Consensus measures the futures market sentiment each day by following the trading recommendations of leading commodity trading advisors. It too is published in Barron’s or can be found at the Market Vane Web site (www.marketvane.net).
Interpreting Sentiment Values
Perhaps the next logical question would be how do you use the values of sentiment surveys in your investing? Investors Intelligence, Hulbert, Consensus, and Market Vane poll investment managers, advisors, and professional investors, so their results provide you with the sentiment of the “smart money.” The traditional wisdom is to trade in the direction of the smart money: Professionals may be privy to information that the general investing public is not and, therefore, they make more-informed buy and sell decisions. When the smart money is feeling bullish, you should be buying and when they are bearish you should sell, or at least refrain from buying.
However, this philosophy can get a little fuzzy when you have to determine the levels for “extreme” bullishness and bearishness. Probably the best way in which to use these values is to compare them with historical levels—if you see the survey reaching all-time levels for either bearish or bullish, you should expect that a market is probably nearing a bottom or top, respectively.
Further complicating the smart money argument, however, are those that believe that even when the experts are extremely positive (or pessimistic) on the market, we are nearing a market top (or bottom). The reasoning here is that as the experts become more positive, the more fully they are invested. Therefore, there is less smart money flowing into the market to sustain the upward push in security prices. As demand dries up, prices will begin to falter. On the other side of the coin, when the experts are overly pessimistic on the market, chances are they have pulled all of the money they wish to out of the market. As the flow of money out of the market subsides, prices should stabilize—forming the market bottom.
Surveys that poll the general investing public, such as the AAII Sentiment Survey, are generally viewed only in a contrarian light. Unlike the smart money, which is believed to have a better insight into the goings-on in the market, the general public is viewed as being less informed. They tend to be convinced of the current trend only after it is firmly entrenched. The old saying that once your barber buys stock the bull market is over applies to this situation—when the least savvy are buying stock, this is a signal that demand had reached its peak. There is no one else to buy.
As we know from simple economics, when demand falls or disappears for good, the price will inevitably fall. Therefore, as you see a survey such as this becoming more and more bullish, you should be on the lookout for a market downturn. Likewise, if the participants are becoming increasingly bearish, you should expect the market to rise in the near term.
No matter how you use the results of sentiment surveys, it is important to view them in the context of the overall market and economic environment and not in isolation.
Beyond conducting polls to gauge market sentiment directly, you can also look to trading and market data to gain insight into the sentiment of the market. The information used by these indicators can include short selling, put and call option trading, odd lot purchases, block trading, and more.
Odd Lot Balance Index: The OLBI shows the ratio of odd lot sales volume to odd lot purchase volume. An “odd lot” is a stock transaction of less than 100 shares. Transactions of this size are usually made by the smallest of traders who are viewed as being the least informed. For this reason, the OLBI is a contrarian indicator. When the OLBI is greater than one, there are more odd lot sales than buys, and vice versa. Increases in OLBI value indicate that “odd lotters” are becoming more bearish, meaning you should go against this group and buy. Likewise, as the OLBI falls, the odd lotters are bullish—this typically indicates a market high, which means you should be looking to sell.
The usefulness of the OLBI as a contrarian indicator has eroded over the years as large traders have begun placing trades of less than 100 shares in order to avoid exchange “up-tick” rules, which stipulate that specialists can only take short positions when prices are moving upward.
Odd Lot Short Ratio: Another indicator making use of odd lot transactions is the OLSR. However, it measures the daily ratio of odd lot short sales to total odd lot transactions (long and short). The OLSR has held up better over time as a contrarian indicator of market highs and lows. When the OLSR is rising, the odd lotters are feeling increasingly bearish—increasing their number of short sales in proportion to the total number of odd lot transactions. A falling OLSR means that less of the odd lot transactions are short sales. From a contrarian viewpoint, a rising OLSR indicates a buying opportunity and a falling OLSR a selling opportunity.
Bull/Bear Ratio: This indicator is an adaptation of the Investors Intelligence survey—the ratio of bullish advisors to the total number of bullish and bearish advisors (neutral advisors are ignored). Illustrating our earlier discussion regarding sentiment, this indicator tends to be contrarian in nature. High readings of the bull/bear ratio are bearish (there are too many bulls) and low readings are bullish (there are not enough bulls). When the bull/bear ratio becomes extremely high or low, the market has generally formed a near-term top (high bull/bear ratio) or bottom (low bull/bear ratio).
Large Block Ratio: This market sentiment indicator shows the relationship between large block trades, which are trades of more than 10,000 shares, and the total volume on the New York Stock Exchange. The comparison of large block trades to total volume shows how active the large institutional traders are. The higher the large block ratio, the more institutional activity is taking place. A high number of large block trades in relation to total volume often coincides with market tops and bottoms. This occurs as institutions recognize the extreme overbought or oversold conditions of the market and place trades accordingly. This interpretation of the large block ratio assumes institutions are in tune with what is taking place in the market.
Short Interest Ratio: This is perhaps one of the most popular measures of market sentiment. Short interest is the number of shares that have been sold short and not yet repurchased. The short interest ratio takes the mid-month New York Stock Exchange short interest and divides it by the average daily trading value over the preceding four weeks. A short interest ratio of one means that the total outstanding short positions are equivalent to roughly one day’s trading volume (Figure 3).
A rising market typically follows high short interest ratios, while low ratios are generally followed by a declining market. This is due to the fact that short sellers have historically been wrong when it come to forecasting market direction. A rising short interest ratio shows that short sellers are becoming more bearish and a falling ratio is a sign of increasing bullishness among short sellers. A second, and perhaps more compelling, reason for the short interest ratio’s usefulness as a contrarian indicator, is because the higher the short interest, the more shares that must be bought in order to cover the short trade. Therefore, the short interest ratio can be used as a proxy for future demand and buying.
One note of caution when using the short interest ratio—it tends to exhibit monthly seasonality bias. Volume in the New York Stock Exchange, historically, has been heaviest during the winter months and trails off through the summer months. Short selling tends to peak in November and December, as people short sell for tax purposes, and in January as investors offset covering transactions.
Member Short Ratio: The MSR measures the short selling activity of members of the New York Stock Exchange (and is the inverse of the public short ratio, discussed below). “Members” trade on the floor of the exchange either for their own account or for their clients. A high MSR indicates more member short transactions and a low MSR translates into less member short transactions (more member long transactions). Assuming that the smart money is indeed smart, which has been called into question in recent years, you should be short when the MSR is high and be long when the MSR is low.
Public Short Ratio: The PSR shows the relationship between the number of public short sales and the total number of short sales. The interpretation of the PSR assumes that the public does not know the true direction of the market. If this is true, then we should buy when the public is shorting and sell when the public is long. Historically, this premise has held true. Generally speaking, the higher the PSR, the more bearish the public, and the more likely prices will increase (given the above premise).
Total Short Ratio: The TSR shows the percentage of short sales to the total volume on the New York Stock Exchange. As with the public short ratio, the total short ratio takes the contrarian view that short sellers are usually wrong. Odd lotters are typically the worst of the short sellers, but history has shown that specialists tend to over-short at market bottoms. High values of the TSR indicate bearish expectations and low values indicate bullish expectations. Taking a contrarian stance, when the TSR is high we would expect the market to rise. Likewise, extremely low levels for the TSR indicate the increased likelihood of a market decline.
Put/Call Ratio: The put/call indicator shows the relationship between the number of puts to calls traded on the Chicago Board Options Exchange CBOE. A call gives an investor the right to purchase 100 shares of stock at a pre-determined price. Investors who purchase calls expect stock prices to rise in the coming months. Conversely, a put gives an investor the right to sell 100 shares of stock at a pre-set price. Investors purchasing puts expect stock prices to decline.
Because investors who purchase calls expect the market to rise and investors who purchase puts expect the market to decline, the relationship between the number of puts to calls illustrates the bullish/bearish expectations of these investors.
Historically, options investors have done a poor job of timing market reversals, as the market tends to move in the opposite direction as their sentiment would seem to indicate. For this reason, the put/call ratio is another contrarian indicator.
The higher the level of the put/call ratio, the more bearish these investors are on the market. Conversely, lower readings indicate high call volume and thus bullish expectations. When it reaches “excessive” levels, the market usually corrects by moving in the opposite direction (Figure 4).
Volatility Index VIX: The VIX measures positive and negative sentiment as measured by S&P 100 index OEX options activity. A rising VIX indicates that negative sentiment is growing while rising optimism is marked by a falling VIX. Historically, the majority of put/call buyers are wrong—making the VIX another contrarian indicator. Therefore, a rising VIX is an indication that the market is becoming oversold, meaning a short-term bottom may be approaching. Likewise, when the VIX reaches low levels—the market is overbought—we can expect a possible short-term top to the market (Figure 5).
Stock Margin Debt: This is the total amount of money owed New York Stock Exchange members by customers who have bought stock on margin (borrowed money). Tracking this data over time is useful because margin traders tend to be most overextended at market tops, while at market bottoms margin accounts tend to be low. In addition, margin account activity can have a measurable impact on market trends. Increasing stock margin debt tells us that more people are buying stock, albeit on margin. Money flowing into the market should boost stock prices. However, if margin debt is falling, this is an indication that money is flowing out of the market—people are selling stock in order to repay the money they borrowed.
The trend in stock margin debt is more important than its aggregate value. If you were to track the level of margin debt over the last few decades, invariably you would see an overall increase in the level of margin debt. However, much of this is due to the fact that stock prices and trading volume have increased over this same period. Therefore, you should concern yourself with trends and changes in these trends. When the amount of stock margin debt is rising, the odds are favorable that the market is rising, while a falling level of margin debt is indicative of a potential market downturn.
Magazine Cover Indicator
This indicator does not involve polling figures or market data. Instead, all you need to do is to go to your local newsstand and look at the cover stories of the major magazines. While relatively obscure and less conclusive in its usefulness, the “magazine cover indicator” called the market bottoms of 1969, 1974, and 1990 within a month or two. This indicator, too, is a contrarian indicator—if several major publications are biased in the same direction regarding the market, then chances are the trend is firmly entrenched. It may be so well entrenched, in fact, that it’s nearing the end and a market reversal is not far behind. This would bode well for investors who have been bloodied by the dramatic turnaround the market has experienced recently: Over the past few months, such prominent publications as Newsweek, Time, and U.S. News & World Report have all run cover stories on the fall of the market and the new bear market. Now, only time will tell whether this indicator is marking the coming of an upward market reversal.
While market sentiment surveys and indicators may be helpful in predicting the short-term movement of the market, they should never be the sole basis for buy and sell decisions. Furthermore, as the dynamics of the market change, the usefulness of these indicators changes as well. As a result, there are no “hard and fast” rules you can apply to market sentiment indicators. The accompanying box provides information on where to find the surveys and indicators discussed here.
Before you use these sentiment indicators as part of your investment strategy, it would pay to do a little legwork on your own to see how these indicators have behaved historically as well as over recent periods. In the end, you will be a better-informed investor.
Where to Find Market Surveys and Indicators
AAII members can access the latest results of the weekly Sentiment Survey in the Member Surveys area under Community. You can also view results for the past six months and download a spreadsheet file with data back to 1987.
The AAII Sentiment Survey, Consensus Index, Investors Intelligence, and Market Vane are carried weekly in Barron’s—look for Investor Sentiment Readings in the Market Week section.
Chicago Board Options Exchange CBOE
The CBOE Web site offers daily market statistics going back to 1995, open interest on a variety of index options, and volatility indexes on the Nasdaq100 index VXN and index options VIX. Visitors can also download historical data files on the VXN and VIX.
At the TSC Metrics section of the Web site, visitors will find a selection of “sentiment signposts.” The AAII Sentiment Survey and put/call ratio are both provided for free.
Wall Street Courier
The Wall Street Courier site offers a broad collection of market indicators and statistics presented in chart form. Some of the information provided includes daily call/put ratios for all CBOE options and CBOE equity options, NYSE short interest ratio, odd lot/floor trader short sales ratio, specialists/public short sales ratio, and VIX oscillator. Updated charts, containing the latest data and five years of data, are only available to subscribers. Subscribers can also download historical data files for selected indicators. Subscriptions to the site begin at $15 for one month, discounted to $40 for six months.
More Information at AAII.com
“A Look at Different Measures of Short-Term Influences on Prices,” by John Bajkowski, July 2000 AAII Journal. Locate by using the search tool. Go to Advanced Keyword Search and select “sentiment measures” from the keyword box.
“Short Sales Trading Strategies.” Found in the Stock Screens area under Specialty Stock Screens. Provides explanation and performance chart for three stock screens: short interest ratio, short interest as a percent of outstanding shares, and largest monthly change in short interest.