Interpreting Market Sentiment (Originally published 12.20.10, updated 01.31.12). Analysts have long noted that extreme investor sentiment can provide a “contrary” indicator regarding the future direction for stocks (meaning that when the investors are extremely bullish, markets often suffer corrections, and when investors are extremely bearish, markets are often poised for big gains).
One of the most famous examples of sentiment as a contrarian indicator occurred in the late 1970s/early 1980s, when investors and the media all but abandoned equities (see headlines below).
Of course, starting in late 1982, the greatest bull market of all time began -- markets were in a general bull trend for the next 18 years.
Now, after a year in which the NASDAQ index rose almost 18%, and the S&P 500 rose 11%, investors are apparently very bullish about stocks as of year-end 2010. The American Association of Individual Investors survey shows individual investors are more bullish than they’ve been in years:
And money inflows into equity mutual funds have not been this high since 2006 (the year before the financial crisis):
So, of course, the mainstream media is wildly enthusiastic regarding the prospects for equities in 2011:
You can listen to technical analyst John Wilson describe some of this disturbingly bullish sentiment on CNBC (12.20.10):
This was the assignment associated with this article in 2010: Observe the stock market action this week and next (which will feature light trading volume because of the two holidays) and ask yourself -- does all this optimism mean that stocks are heading for more big gains in 2011, or should we interpret the optimism as a contrary indicator, meaning that stock valuations first need to “correct”, with price declines of 5%-15%, before stocks can move appreciably higher? Epilogue: 2011 turned out to be a year of high volatility but zero total return for most major equity markets. In this case using sentiment as a contrarian indicator would have paid off, because you would have had less exposure to the negative risk-adjusted returns equities provided in 2011.
