The Struggle to Profit From Investor Emotion

Traders are aching to know how you feel, what you hope and expect for the future. No, they don't truly care. They just want to gather evidence that your feelings about the market are excessively popular -- and bet against you.

Today on Wall Street, it sometimes seems that all anyone wants to know is what “everyone else" thinks about the market. When this phantom “everyone” is optimistic, the typical edge-seeking trader wants to play for the market to drop, and vice versa. Here we have many investors fixating on what “most” investors are doing, for the purpose of doing the opposite -- a bit like a game of spy-vs.-spy played in a hall of mirrors.

Of course, the theory of contrary investing -- profiting by going against the crowd -- is as old as organized markets, the folklore rich in sage advice to buy when blood runs in the streets and sell as victory trumpets sound. Yet the constant monitoring of investor psychology as a coveted performance edge has become a dominant practice.

This is thanks to a 13-year stock-market trading range featuring wide emotional swings, in which tactically twitchy hedge funds emerged as the key swing constituency in the market, using new technological tools to measure and disseminate sentiment indicators.

The market mood

So, yes, by most lights the market mood right now has become too upbeat and insufficiently fearful for this gentle, daily climb to persist much longer. But when does that observation itself become "too popular" to be very useful? (Maybe when articles are published questioning the popularity of contrary investing?)

The hedge-fund mindset -- in which exposure to market risk is dialed up and down frequently in an effort to outwit, or at least slightly outrun, the herd -- lends itself to over-reliance on sentiment-based bets. Hedge funds seek and promise "absolute returns" in any market environment. With low rates and choppy stock markets since 2001, there simply hasn't been enough absolute return in the world to go around for all those hunting for it.

This engenders an attitude that every dollar one makes comes from someone else's pocket. (This backdrop would shift should the market's reach escape velocity and embark on a new enduring uptrend, but that's hardly a given.)

Statistics on newsletter writers' recommendations, investment surveys, futures traders' betting patterns, options prices and fund flows have gone from relative obscurity to the stuff of real-time trading-desk and online chatter.

The view from Twitter

Discount brokers TD Ameritrade and Fidelity Investments have in recent weeks debuted investor sentiment measures based on the activity and opinions of their respective active-trader clients. Derwent Capital last week launched an investing platform based on sentiment vapor trails detected on Facebook and Twitter -- a forum distinctly geared toward "everyone's bullish so I'm bearish" bluster, as well as enticing quanta of stock-specific analysis and advice.

The field is crowded enough that Jason Goepfert's www.SentimenTrader.com tracks dozens of sentiment gauges daily. Goepfert's work is especially useful in this environment, because he provides crucial nuance in interpreting the mosaic of clues, mindful of how frequently and with how much timeliness each data item tends to be predictive of market action.

One common error that sentiment-studying investors make is to ignore the context of the market's recent performance when declaring the public is leaning too far one way or another. In a market calmly making new five-year highs -- the S&P hit 1,500 on Thursday for the first time since December of 2007 -- a palpable happy feeling among most investors is merely to be expected. So the threshold for "too optimistic" judgments is higher.

For what it's worth, among Goepfert's daily sentiment "tells" that are now at an extreme, 21 imply investors are too upbeat (and thus are bearish for stocks), against only one showing excess pessimism. Yet such setups can persist for some time, overcome by sheer market momentum or the power of big news. That has been the case this month.

Momentum markets

"These momentum kinds of markets are extremely difficult, as they flout historical precedents for weeks on end, until it stops, and we wipe out most of the gains," Goepfert says. "We may be on the cusp of another one of those times, but for now our work is not showing a strong edge either way."

One of the intriguing clues now is the Credit Suisse Fear Barometer, a calculation of how much big-money players are willing to pay up for downside options protection compared to speculative upside plays. Unlike many such gauges, this one hasn't been a wrong-way contrary indicator but a hint of "smart-money" prescience.

When it reached current levels four times in the past three years, stocks either soon stalled or suffered sharp declines -- though interestingly, the signal was "ignored" for a while early last year as stocks' first-quarter rally carried on for several weeks while the Fear Barometer flashed danger. Combine this with a fresh happy extreme in a time-tested contrary indicator -- the most bulls in the weekly American Association of Individual Investors poll in two years -- and the mood signals are flashing market warnings.

Worth noting -- but don't go telling "everyone."