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Investing 101: Using market sentiment to your advantage


For this installment of Investing 101, we'll take you through the process of how research firms and Wall Street strategists determine investor, or market sentiment.

Market sentiment is a relatively new calculation that polls market experts, analysts, and strategists on their overall feeling on the market. The goal, according research maestro Paul Hickey of Bespoke Investment Group, is “when you look at sentiment in the market, you want see what investors’ thoughts are on the market.” Call it the market zeitgeist if you will. One of the oldest sentiment surveys is the American Association of Individual Investors, or AAII Sentiment survey. The AAII survey started as a weekly survey in mail-in poll in 1987. The poll now is done online, and released on Thursdays.

Some research shops even take into account trading data like block trades and short interest, and trends in stories published by financial news publications. Hickey’s Bespoke also tracks something known as the “ten-day advance decline line” for the S&P 500 (^GSPC), a metric that tabulates the number stocks that were up versus the number of stocks that were down, and over ten days the more negative the number, the more oversold the market is (meaning a short term pop could be coming up).

And that’s the paradox with market sentiment, in that these polls, or readings, are typically reflecting where the market has been, and not where it’s going. Invariably this has lead to the survey predicting that the market will go against the majority, meaning periods of high bullishness lead to eventual sell-offs, and periods of downturn and market bearishness signal a market bottom.

“If everyone’s bullish on the market at the same time, then there’s less people to convince to get into the market, so there’s less future demand,” Hickey says, but conversely when more people are bearish, “eventually those people are going to turn bullish if the market turns around, and that’s going to create more demand for stocks.” Hickey notes that the peak in recent bullishness was reached at the end of last year, thus leading to a not so unexpected weak January for stocks.

Turning to where investor sentiment is now, Hickey notes that bullishness has been decreasing for four straight weeks. In addition, bearish sentiment is now greater than bullish sentiment for the first time since Mid-August of 2013.

So what does this increasing bearishness mean for the market today? Hickey surmises that “if we see another week or so of bearish sentiment ticking higher that would be a good sign for equities.” Investors are likely hoping he’s right.