Trader Q&A: The Sentiment Indicators You Should Be Watching

Schaeffer's Quantitative Analyst Chris Prybal offers up a few of the sentiment indicators he's been watching

by Karee Venema

    Published on Aug 12, 2015 at 11:17 AM
    Updated on Aug 12, 2015 at 11:23 AM

    Here at Schaeffer's Investment Research, our success in trading is based on a 3-tiered methodology we call Expectational Analysis® . This approach combines fundamentals and technicals with sentiment indicators to create a more well-rounded analysis for traders. Specifically, we place such significance on sentiment indicators because they provide a snapshot into the collective feelings of what the majority of investors are feeling -- and helps a contrarian sift through the noise.

    So, which sentiment indicators should we be watching? I sat down with Schaeffer's Quantitative Analyst Chris Prybal to pick his brain on sentiment analysis -- and watch him skirt the age-old question "east side or west side."

    • Are there certain sentiment indicators you prioritize/prefer over others? My favorite sentiment indicators include the gamma-weighted Schaeffer's put/call open interest ratio (SOIR) and the equity-only put/call volume ratios, both on individual equities and on the market as a whole. These indicators reveal the emotional bias of marketplace, as well as potential support/resistance areas.

    • Are any of these flashing any signals at the moment? There is an elevated level of fear and caution ahead of the Federal Open Market Committee's (FOMC) next interest-rate increase. As this fear increases, put/call ratios become elevated to levels that historically have had a contrarian outcome. And, subsequently, when an equity/index consolidates into a support area or a moving average and you have the bearish backdrop of elevated put/call ratios and put support immediately beneath shares, the chances of a positive outcome are increased in your favor, as you have multiple support mechanisms/backdrops in addition to a negative emotional bias exemplified by increased put activity.

    • Are there certain indicators that support a shorter-term outlook versus a longer-term one? I would consider put/call ratios and the gamma-weighted SOIR as short-term indicators. What you are really trying to decipher is whether or not an extreme has been reached in sentiment compared to history, and is the rationale justified. Buying fear and selling greed continues to be a winning strategy in today's marketplace.

      From a longer-term perspective, I like to compare asset classes -- their potential risk and potential return versus one another. Human beings tend to herd in behavior, and what is working today may not be working tomorrow. And, vice versa, if an asset class is producing horrible returns and the financial media is caught up in the negative rhetoric, one must ask if that asset class is due for a correction or a change in trend. The cyclical nature of markets is alive and well, even in a zero or near-zero interest-rate environment. Volatility, like price action, is cyclical, and has both short- and long-term implications, whether you are speculating for the short term or extending your time horizon for the long term.

    • Are there certain indicators that are more publicized than others, or that you've noticed don't necessarily tend to pan out? I'd like to take this question a different way and discuss earnings per share (EPS). I mean really, is this the only place where pennies still matter?

      Each quarter, each company gets analyzed based upon this measure of profitability. It seems pretty obvious to me that this figure can be manipulated for various reasons, and we see it happen all of the time. Financial rewards for corporate executives are often based off EPS, at the expense of the buy-and-hold stakeholder. It would be nice to see a more thorough examination of a company's financial health. Unfortunately, this takes work, and we settle on basic financial reporting such as EPS. And, at the end of the day, the primary driver of an equities price is expectation of future revenue/income. It is difficult to quantify future growth.

      In summary, I feel financial reporting should be more transparent and not geared so much on short-term rewards versus long-term viability. Therefore, I view EPS as a highly publicized measure or indicator of health that receives most of the attention, which may or may not be as relevant as investors perceive, especially in a forward-looking pricing mechanism such as the stock market.

    • Anything else you'd like to include? Exhibit patience, and have a longer-term horizon. While it is attractive and exciting to cash out big wins from the market over a short timeframe, realize that you are also taking bigger risks with your capital. Try to buy more time for your premium purchases, while you pay up for the extra time -- it gives you more flexibility on management of position. Market timing is difficult, give yourself leeway when prognosticating future direction of an asset or asset class.
    For Fun

    • Which is better -- the east side or west side of Cincinnati? I've got relatives on both sides; I'm agnostic.

    • As a University of Cincinnati graduate, how's the new Nippert Stadium looking? The new stadium looks great. I cannot wait to venture into the new suites and revel at the amazing views of campus. Hopefully, the results on the scoreboard propel my giddiness.

    • What's the best trading advice you've been given? Do your own research. Ask a lot of questions. If you don't have an answer you're comfortable with, do the thorough research to prove/disprove a theory or notion.

      Your success will be predicated by the time you put in. Even though it's not trading advice, I like to remind myself of a Vince Lombardi quote "The only place success comes before work is in the dictionary."

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