3 Sentiment Indicators That Will Change Your Trading

Find an edge in your trading with these 3 sentiment indicators

by Elizabeth Harrow

Published on May 19, 2015 at 1:54 PM

Sentiment analysis is not a widely used methodology, but it is the cornerstone of the way we at Schaeffer's Investment Research approach the market. Over three-plus decades, we've learned that it pays to take a contrarian approach to investing. To paraphrase Warren Buffett, we're fearful when others are greedy and greedy when others are fearful.

But sentiment analysis might seem like a peculiarly subjective pursuit, particularly to those who thrive on hard facts and figures. To demonstrate how important (and how surprisingly data-driven) sentiment analysis can be, here's a look at three of our favorite indicators.

1. Investor Sentiment Polls

As an indicator, investor sentiment polls are pretty straightforward -- they offer a comparison of the percentage of respondents who are bullish versus those who are bearish. Two of the most popular surveys we track are those compiled by Investors Intelligence (II), which conducts a weekly poll of financial advisors, and the American Association of Individual Investors (AAII), which asks its membership each week whether they're feeling bullish, bearish, or neutral toward stocks.

As contrarians, we look for situations where these surveys show a high percentage of pessimism while stocks are moving higher. This indicates to us that not everyone has bought into the rally, and there are still plenty of sideline buyers who could contribute to additional upside. Alternately, if everyone is optimistic in the midst of a bear market, that's a troubling sign that the downtrend may continue until these remaining bulls have capitulated.

AAII Bears SPX

It never fails -- once a good portion of the crowd is looking for a correction, you can guess what usually happens. Back in July 2013, we noted the number of those surveyed in the II poll looking for a "correction" was up over 35%. Going back to 2010, the five previous times this rare occurrence happened, it marked a great buying opportunity four of those times. Sure enough, history was on our side as the market gained nearly 5% in July, making it one of the best months in a historic bull move in 2013.  

2. Mutual Fund Flows

Mutual fund flows are one way of "following the money" to see how investors are feeling about the market. When investors are feeling bullish, with higher risk appetites, we tend to see net inflows into equity-based funds and outflows from bond funds. Conversely, a risk-off attitude might spark inflows for bonds and outflows from equities.

The Investment Company Institute is a great resource to track this information. In addition to following the activity in stocks vs. bonds, you can also determine whether investors are flocking toward domestic equities or global funds.

Quite simply, mutual fund flows help us to determine how much investors have poured into stocks relative to bonds, and whether one side of the trade might be getting a little crowded. If the equities market is moving higher, and we have yet to see significant inflows into equity funds relative to bonds, it can be a signal that there are still plenty of potential buyers out there to perpetuate future gains.

Domestic Equity 12-Month Flows SPX

In fact, one of the main reasons we expected higher prices in 2013 was the huge disparity between money going into bond funds versus domestic equity funds. As early as February, we noted there was a record difference in 12-month flows into bonds and out of domestic funds.  In the end, 2013 was the worst year for bonds in a generation and one of the better years ever for domestic stocks. Following (and fading) what the masses were doing correctly predicted the price action in 2013, and it will work again in the future.  Why? Because the crowd is usually very wrong at the extremes.  

3. Short Interest

As you may already know, short interest is the number of shares sold short on a given equity. Short interest is created when an investor sells stock that is borrowed from a broker in the hopes of buying the stock back at a lower price in the future. In other words, the trader is looking to profit from a drop in the share price -- essentially setting up a "sell high, buy low" scenario.

A high level of short interest signals pessimism, since it indicates a relatively large number of investors are banking on shares to fall. When short interest is high, and the underlying stock rises, the positive price action can force short sellers to buy back their shares to limit losses. This "short covering" activity results in additional buying pressure for the stock.

One of our favorite indicators is the total short interest on all S&P 500 Index (SPX) components.  We’ve found that when this metric is high and begins to roll over, it can suggest an imminent bull move in equities.  As all of those shorts start to cover, it can produce significant buying pressure.  

Total Short Interest SPX

When the SPX was breaking out to new highs in early 2013, we noted the huge level of short interest out there could produce just this type of massive short-covering rally. By the way, this was at a time when all the fundamental analysts were worried about things like earnings and a slowing economy.  In retrospect, we know how wrong they were in the face of a 29% SPX advance, and those shorts were a clue as to how potent the rally could be.

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