Sentiment Indicators Can Help You Trade Against the Crowd

Many financial news web sites have adopted the local television news mentality, which is “if it bleeds, it leads.” News shows and news sites have two purposes – they hope to provide useful information but they must create an audience large enough to interest advertisers. To get viewers on television or clicks on the web, news sites often try to shock readers with bad news that will hold a consumer’s attention long enough to allow for ads to be presented. Ultimately, most news sites exist to deliver ads and the news is just a way to get the ads to load on your device.

If you obtained all your news from headlines on financial web sites, you would have learned:

  • Citi: When thinking about monetary policy today, think about hyperinflationary 1920s Germany
  • Wall Street has been rocked by an $8 billion hedge fund’s implosion
  • El-Erian: Rajan’s exit is bad news, and not just for India

Those were headlines on Yahoo! Finance, one of the more balanced financial news sites. Reading the stories, we learn that monetary policy right now is really much different than it was in the 1920s; the hedge fund was closing because of problems related to insider trading and other legal issues; and the exit of the head of India’s central bank was widely expected.

Because many investors don’t read more than headlines, stories like this have resulted in many becoming bearish. When too many investors become bearish, that’s actually bullish for the market. And, on the other side of the equation, when too many investors are bulls it might pay to be bearish.

There is a logical reason for this.

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Whenever a large number of investors hold the same opinion, it’s likely they are invested in a similar way. Bears are usually holding some cash and when there are a large number of bears the market tends to rise when they eventually decide to put that cash to work. As more and more bears throw their cash into the market, prices go higher and rising prices draw other bears off the sidelines. The result is often a large gain in price.

A large number of bulls indicates there is unlikely to be much idle cash in investor’s accounts. When “everyone” is bullish and fully invested, traders say the market runs out of buyers and prices fall. This is the typical pattern seen at important market tops.

Sentiment indicators are designed to help us spot times when bulls or bears are at extremes.

One group of sentiment indicators are based on surveys. Every week the American Association of Individual Investors (AAII) asks members, “do you feel the direction of the market over the next six months will be up (bullish), no change (neutral) or down (bearish)?” The weekly data and historical results are then made available for free.

The chart below shows when the number of bulls (the blue line) is unusually high, stocks tend to sell off and a low number of bulls tends to be seen at bottoms.

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Only extremes in the data provide useful information. As of this week, the latest AAII data from June 15 is not offering a buy signal. According to AAII, “Bearish sentiment rose to its highest level and neutral sentiment fell to its lowest level since February. Even with the big jump, pessimism remains within its typical historical range.” This demonstrates sentiment indicators will not always provide tradable information.

Another popular sentiment indicator is known as the “magazine cover” indicator.  The concept behind this indicator is that when a market is popular enough to be featured as a cover story of a magazine, the trend is most likely near an end. One example is the famous BusinessWeek cover proclaiming the “death of equities” in 1979 after a 13-year bear market. The next 20 years would prove to be the best twenty-year period for stocks in history.

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Magazine covers also worked at the top of the market in 2000 as they featured successful day traders and popular internet companies. While this indicator is useful and easy to follow, it is also rare.

News stories, as we saw above, do offer some insight into sentiment nearly every day. Almost all economic news, for example, will be different than expected. Every month the unemployment rate is reported as better than expected or worse than expected. Expectations are derived from a survey of economists and their sentiment is included in their estimates. When economic news consistently beats expectations, as it has been recently, economists are bearish. This provides the proverbial “wall of worry” a bull market needs to climb.

A third type of sentiment indicators are based on what real investors are doing with their money. These indicators might be the most useful for trading.

Years ago, there were many of these indicators. Analysts in the 1980s would study odd-lot transactions (trades of less than 100 shares) to see what individual investors were doing. They would also look at the amount of cash mutual fund managers held. These indicators, and many other sentiment indicators, are no longer useful. With high frequency trading, thousands of trades a day are now completed for less than a hundred shares. This is a change in market structure that made the odd-lot indicator worthless to track. ETFs now hold trillions of dollars and mutual fund cash levels are no longer meaningful, especially since large firms like Fidelity and Vanguard place strict limits on cash that managers can hold.

One sentiment indicator that is still useful is the data in the Commitment of Traders (COT) report. This is a report of various position in the futures market. Information about trading in S&P 500 futures can provide valuable information to stock market traders.

Futures markets are regulated by the Commodity Futures Trading Commission (CFTC) and to prevent market manipulation large traders are required to report their holdings every week. The CFTC knows how many contracts are currently trading in each market so they can subtract the positions of large traders from the total to determine what positions small traders hold. In the futures markets, small traders have, on average, not done very well. Following information about small traders in the S&P 500 futures can provide a trading signal based on contrarian thinking.

Contrarians go against the trend. They are bulls when most investors are bearish. This is a popular method of analysis but it is important to remember that the crowd, or the majority of investors, is only wrong at market turning points. Most of the time, bulls are pushing markets up but at some point, we run out of bulls and markets collapse. This simple fact explains why surveys and magazine covers provide rare signals. But the COT data is different. In the futures markets, small traders are consistently on the wrong side of the market.

Futures contracts all have an expiration date. Traders in these contracts are almost always leveraged, using a small amount of money to control a relatively large investment. That means small traders usually don’t have time to let a losing trade recover since their losses can grow quickly and there isn’t time to take the long-term perspective there is with stocks.

The chart below shows the positions of small traders in the e-mini S&P 500 futures contract. Notice how they have been consistently wrong throughout 2016.

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Using COT data allows us to measure sentiment by looking at what traders are doing with real money, unlike surveys which are based on what investors say they believe. That makes the COT report perhaps the most useful sentiment indicator. This data is released by the CFTC every Friday at 3:30 Eastern time and is available for free.

While sentiment data is useful, it’s best to use sentiment data as one input into trading decisions. The COT data can be monitored weekly and when small traders are bearish it can be pay to be bullish. Surveys can also be monitored weekly and when sentiment is at an extreme, it can be time to take aggressive action. It’s usually best to use price data to confirm the sentiment indicators. If investors are bullish in surveys and bearish in the COT data, a break below a moving average should not be ignored. That should be a sell signal that you take as a warning that further declines are likely.

Right now, sentiment analysis is bullish and supports higher prices in the stock market.