The Importance of Sentiment and Timing

Paying attention to investor sentiment can give traders important clues about where the market may be headed next

Jul 8, 2016 at 11:03 AM
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Traders are always looking for an advantage, and staying ahead of the market curve is the best way to maximize profits. Here at Schaeffer's, one of the three tiers of our Expectational Analysis® methodology is sentiment. Combined with fundamental and technical factors, sentiment can be a powerful tool for analyzing stocks, sectors, or the overall market. And, as contrarians already know -- and as we will demonstrate below -- there is often money to be made in going against the crowd, if you time it right.

There are four stages of sentiment: despair, disbelief, acceptance, and euphoria. Market bottoms and tops typically happen when sentiment reaches an extreme. For instance, when Wall Street is "euphoric" after a sustained rally, that suggests buying power is likely exhausted. When there is an exceptionally high number of bears after a sustained downturn, and Wall Street is in "despair," a bottom may be close at hand.

There are also many ways to measure investor sentiment, including magazine covers, short interest, analyst opinions, option trends, and polls. The table below displays the three-month returns of the S&P 500 Index (SPX) based on price action and investor sentiment, as measured by the Investors Intelligence (II) poll, courtesy of Schaeffer's Senior Quantitative Analyst Rocky White.

Data is based on three-month returns from 1975 to present, with price action determined by where the SPX was in relation to its 40-week moving average. A range of 54.75% below to 0.93% above the trendline is quantified as "negative" price action, a range of 0.95% to 6.09% above is considered "moderate," while anything over 6.09% would be considered "positive."

The first three columns of the table correlate to whether II polls showed pessimism, moderate sentiment, or optimism. Average investor sentiment was found by subtracting bulls minus bears, using II poll data since 1975. If the bulls-minus-bears equation worked out to -43% to +5%, sentiment is considered "pessimistic," a range of 5% to 24% is considered "moderate," and anything over 24% is considered "optimistic."

SPX Investor Sentiment Three Month Return Action

As shown on the table, returns are the highest when the price action is positive but investor sentiment is negative, with an average three-month return of 5.12% for the S&P. When there is negative price action but investor optimism, the average return is -1.59% -- the lowest of all the readings on the table.

In general, investor pessimism seems to lead to higher returns (3.80%, on average, regardless of price action), while optimism leads to the lowest returns (1.35%, on average). The current market sits within the "moderate" range for both price action and sentiment, a combination that historically has averaged an S&P three-month return of 2.57%. To see how the S&P performs in the second half of the year, based on II sentiment, read Indicator of the Week: What's In Store for the Second Half of 2016?

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