Saturday, April 9, 2011

Market Sentiment

“There is no fear out there,” a trader in Barcelona said yesterday.  “The bulls are happy to focus on the underlying growth picture, which remains benign, and dismiss short-term negative headlines.”

That is one impression of market sentiment today.  Having a good sense of a market’s mood is crucial for investment success.  The odds of success in entering a cheap, lagging, unpopular market are much greater than they are in entering an expensive market that has already surged, where everyone seems to believe it is a sure thing.

Yet, sentiment measures are generally useful only at extremes.  Even at that, widespread optimism is not necessarily a signal to sell.  Markets in which most participants are bullish tend to continue to rise beyond what one might think is reasonable.  These conditions tend to be associated with a prolonged, rounded period that is marked by double or even triple tops that constitute a broad market top.  Widespread pessimism is, however, typically an excellent signal to buy, as it is usually associated more with an abrupt market bottom.

A longstanding sentiment measure for the stock market is provided by Investors Intelligence, which surveys the sentiment of investment advisors.  It is fairly common for more than 50% of advisors to be bullish in the survey.  The record of market tops being associated with periods when 50% or more advisors are bullish is mixed, with some periods close to stock-market tops, others not at all.

The opposite end is much more conclusive.  Extreme levels of pessimism have been outstanding times to buy.  When the level of bullish investment advisors falls to about 30%, those have been major buying opportunities.  There are numerous examples back to 1973 of such low levels that were followed by substantial rises in the stock market over the following two years, ranging from +20% to +75%.  I found 16 instances—all with gains—that had an average two-year gain of 40%.  They include late 2008/early 2009, late 2002, mid 1997, mid 1994,  October 1987 (after the market crash), and the summer of 1982 (beginning of the great bull market).  I couldn’t find a period when extreme pessimism was not followed by a significant gain in stock prices over the following two years.

Market tops are tricky to identify at the time.  But the next time you notice that the Investors Intelligence survey shows only about 30% bullish advisors, just buy stocks.  (It was recently above 50%.) Don’t worry about the certain negative news headlines at the time.  Just buy.

Steve Lehman

S & P 500:  1328
Russell 2000:  841

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