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Investor Psychology

Tap Into Market Sentiment Before Investing

Find out what the herd thinks, then head in the other direction.

In a story that may be apocryphal, businessman, investor and Kennedy clan patriarch Joseph Kennedy Sr. sold all his stocks before the 1929 market crash when a shoeshine boy gave him a stock tip. If even shoeshine boys are buying stocks, Kennedy reasoned, enthusiasm for stocks must be at the peak.

That makes sense. At major stock market peaks, most people are bullish. At major bottoms, most people are bearish. Sentiment indicators try to figure out just how bullish the Wall Street herd is so that savvy investors can do the opposite.

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The trick with following sentiment indicators is that you must look for maximum bullishness and bearishness. It’s not enough to say, “My neighbor is buying stock in Amazon, so I’m going to sell mine,” even if you think he’s a clod. A better signal would be, “My neighbor is selling his house to buy Amazon, so I’m going to sell my shares.” But that doesn’t happen very often.

One popular sentiment indicator is the American Association of Individual Investors’ weekly survey. The venerable investors’ organization simply asks members whether they are bullish, neutral or bearish. As of mid July, according to the survey, 33.6% of investors were bullish, 38.9% were neutral, and 27.5% were bearish.

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Topsy-turvy. In the upside-down world of sentiment indicators, an extremely high bullish response is a sell signal, and an extremely high bearish response is a buy signal. In this case, current sentiment indicators are telling us nothing particularly useful, except for the fact that AAII member investors are all over the map.

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And that’s not enough to take action. Sentiment indicators work best at extremes, and we are nowhere near extremes. As a rule of thumb, a bullish reading above 48% is a worrisome amount of bullishness, and 40% is an amount of bearishness that should pique your interest. (People tend to be optimistic.)

Those levels aren’t foolproof. Periods of great bullishness can also be great times to invest. In the week of June 19, 1997, for example, AAII’s survey hit a seemingly worrisome bullish level of 59%. A year later, Standard & Poor’s 500-stock index was up 26%. Bullish sentiment didn’t peak until the week of January 6, 2000, when it hit a high of 75% and an epic bear market began.

Other sentiment indicators include the Advisors’ Sentiment Report from research service Investors Intelligence. The weekly poll measures sentiment among professional advisers. Currently, the ratio of bulls to bears is 3.10; a reading above 3 is cautionary, while under 1 is bullish.

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Jim Stack, president of InvesTech Research, thinks that the University of Michigan’s Consumer Confidence survey is probably a better sentiment indicator. “Consumer spending is two-thirds of gross domestic product, and where consumer sentiment goes, spending follows,” he says.

The University of Michigan has three indexes of consumer confidence. The most important one tracks expectations. Extremely low consumer expectations—an index reading below 65—marked market bottoms in 1982 and 2009. A euphoric reading of 117.7 ushered in the 2000–02 bear market, and a moderately high reading of 77.9 preceded the 2007–09 bear. Current level: 89.3.

Because sentiment can be so volatile and unpredictable, it falls into the category of indicators that are worth watching but not definitive. If you’re investing when sentiment is high, you should probably limit your short-term expectations. If you’re buying when sentiment is low, remember that it can always get lower. And unless you’re a Joseph Kennedy, don’t take your investment cues from the person who shines your shoes.

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