If there is one ray of hope to be glimpsed during the global stock market cascade, it may be the sense of hopelessness. Markets often reach lasting troughs when panic and despair pervade trading, and in recent weeks some indicators with successful histories of measuring those sentiments reached rare, sometimes unprecedented, extremes.
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Gauges of investors’ moods can signal price direction
By Conrad de Aenlle
31 October 2008
If there is one ray of hope to be glimpsed during the global stock market cascade, it may be the sense of hopelessness. Markets often reach lasting troughs when panic and despair pervade trading, and in recent weeks some indicators with successful histories of measuring those sentiments reached rare, sometimes unprecedented, extremes.
Emotions, as ephemeral and often incomprehensible as they are, may seem like hard things to quantify, but investment advisers have various tools shown to be accurate gauges of the public’s mood. Some are straightforward opinion surveys of investment newsletter writers, individual investors, homeowners or consumers, while others use mathematical devices to infer sentiment from the prices of certain assets.
Most of the indicators are American, as the U.S. market has more data points to be analyzed. But the signals they send can often be used to reliably forecast price movements elsewhere. Even when local versions exist, technical analysts say, the U.S. measures are often more helpful.
However and wherever the indicators work, their conceptual underpinning is the same irony-tinged rule of thumb: Investors tend to be wrong in their forecasts of the direction of stock prices, and they tend to be most wrong at major turning points.
It seems counterintuitive and even a bit insulting, but it makes sense. The more pessimistic investors are, the more likely that they have already dumped large amounts of stock, leaving them with less to sell and with plenty of cash to put back into the market eventually. The same works in reverse when optimism reigns.
Because people have a habit of becoming optimistic and greedy one by one and panicking en masse, the signals of extreme pessimism are often considered more reliable than the ones pointing to a rosy future.
“When you get extreme bearishness, it creates a buying opportunity,” said Henry Herrmann, chief executive of Waddell & Reed, a diversified financial-services firm in Kansas.
No question about it, there was a preponderance of bearishness in October.
“Pessimism was overwhelming,” Herrmann said. “I’ve never seen anything as broad as what we’ve just seen.”
One sign of it was the anxiety expressed by his firm’s clients.
“I could tell from our customer base that panic had set in,” Herrmann said, noting that many had asked to withdraw their money or at least be reassured that they should leave it where it was.
To Herrmann, it was “the sort of stuff that coincided with major bottoms in the past.”
His anecdotal evidence conforms to more formal indicators like the survey of investment newsletters compiled by the Investors Intelligence service. Bullish opinion almost always predominates, but as the market tanked recently, bears outnumbered bulls by 53 percent to 25 percent, with the remaining newsletters neutral.
James Stack, editor of the newsletter InvesTech Market Analyst, noted that the last two periods when bears exceeded 50 percent were the 1994 correction and 1991 bear market. Both events proved to be excellent buying opportunities. Advisers are more bearish now, Stack said, than at any time during the dot-com crash or in the aftermath of the terrorist attacks of Sept. 11, 2001.
What happens when newsletter editors have a sunnier collective disposition? The highest ratio of bulls to bears in the past three years, about 3 to 1, was early in October 2007, almost exactly at the top of the bull market.
More evidence of severe pessimism among professionals comes from the latest Merrill Lynch monthly survey of global fund managers, released in mid-October. Commentary accompanying the results calls the survey “one of the most pessimistic we have ever conducted.”
“Over the past month, fund managers have lost faith in global growth, commodities, China’s economy and emerging markets,” it goes on to say. “By historical standards, a lot of bad news is now in the price, although the fragility of the financial system means that history may be a less reliable guide than usual.”
In the survey, 17 percent of fund managers described themselves as overweight in equities, including 2 percent who said they were “aggressively overweight.” The 62 percent who said they were underweight was the highest figure in at least a decade.
A popular sentiment indicator that relies less on what investors say and more on what they pay is the Chicago Board Options Exchange volatility index. The VIX uses the pricing of stock index options to calculate the level of market volatility anticipated over the next month.
Heightened expectations of volatility tend to coincide with uncertainty, which goes hand in hand with fear and panic. The VIX reading usually trades from 15 to 30 during placid times. Spikes above 40 often herald imminent market bottoms and have occurred at key turning points, like the depth of the Russian debt default in 1998 and the reopening of the U.S. stock markets after the Sept. 11, 2001, attacks.
The panic was so severe in October that the VIX, which had never been as high as 50 since the measure was introduced nearly 20 years ago, far exceeded that level on several days and nearly reached 90 on Oct. 24.
The VIX is one of several sentiment indicators that led John Buckingham, editor of The Prudent Speculator newsletter, to tell his subscribers that “it is far better to be a buyer than a seller today.”
“Obviously, it would not be a big surprise to see more short-term pain,” he wrote, “but it is nice to know that some of the technical data we look at are flashing a screaming short-term buy signal.”
Buckingham was also encouraged by the fact that 98 percent of the components in the Standard & Poor’s 500-stock index were trading below their 50-day moving average, which is the average closing price of each stock from the preceding 50 trading sessions.
Komal Sri-Kumar, chief global strategist at TCW Group, a Los Angeles subsidiary of the French bank Société Générale, also finds the high VIX readings “a buy signal and one more indicator that the situation is bottoming out.”
Sentiment measures are strong forecasting instruments, but they are not foolproof. Sri-Kumar cautioned that there would probably be one or more retests of the recent low before it was clear that the bear market was over.
“This is not it - we haven’t resolved it,” he said. “We are going to get out of this, but we aren’t there yet.”
One problem with sentiment measures is that once readings become extreme, they can become more extreme still. Anyone who bought stocks when the VIX hit 50 would have suffered through much of the latest plunge.
“You never know until later on whether an extreme was the extreme,” said Herrmann, Waddell & Reed chief executive. “There were lots of indicators suggesting that we were in extreme territory, but if you acted on those, you could have lost another 20 percent.”
One sign of a more secure bottom, he said, would be a retest of recent lows accompanied by sentiment readings that were somewhat less bearish. Until then, he advised investors to recall John Maynard Keynes’s Depression-era admonition: “The market can stay irrational longer than you can stay solvent.”
Gauges of investors’ moods can signal price direction
By Conrad de Aenlle
31 October 2008
If there is one ray of hope to be glimpsed during the global stock market cascade, it may be the sense of hopelessness. Markets often reach lasting troughs when panic and despair pervade trading, and in recent weeks some indicators with successful histories of measuring those sentiments reached rare, sometimes unprecedented, extremes.
Emotions, as ephemeral and often incomprehensible as they are, may seem like hard things to quantify, but investment advisers have various tools shown to be accurate gauges of the public’s mood. Some are straightforward opinion surveys of investment newsletter writers, individual investors, homeowners or consumers, while others use mathematical devices to infer sentiment from the prices of certain assets.
Most of the indicators are American, as the U.S. market has more data points to be analyzed. But the signals they send can often be used to reliably forecast price movements elsewhere. Even when local versions exist, technical analysts say, the U.S. measures are often more helpful.
However and wherever the indicators work, their conceptual underpinning is the same irony-tinged rule of thumb: Investors tend to be wrong in their forecasts of the direction of stock prices, and they tend to be most wrong at major turning points.
It seems counterintuitive and even a bit insulting, but it makes sense. The more pessimistic investors are, the more likely that they have already dumped large amounts of stock, leaving them with less to sell and with plenty of cash to put back into the market eventually. The same works in reverse when optimism reigns.
Because people have a habit of becoming optimistic and greedy one by one and panicking en masse, the signals of extreme pessimism are often considered more reliable than the ones pointing to a rosy future.
“When you get extreme bearishness, it creates a buying opportunity,” said Henry Herrmann, chief executive of Waddell & Reed, a diversified financial-services firm in Kansas.
No question about it, there was a preponderance of bearishness in October.
“Pessimism was overwhelming,” Herrmann said. “I’ve never seen anything as broad as what we’ve just seen.”
One sign of it was the anxiety expressed by his firm’s clients.
“I could tell from our customer base that panic had set in,” Herrmann said, noting that many had asked to withdraw their money or at least be reassured that they should leave it where it was.
To Herrmann, it was “the sort of stuff that coincided with major bottoms in the past.”
His anecdotal evidence conforms to more formal indicators like the survey of investment newsletters compiled by the Investors Intelligence service. Bullish opinion almost always predominates, but as the market tanked recently, bears outnumbered bulls by 53 percent to 25 percent, with the remaining newsletters neutral.
James Stack, editor of the newsletter InvesTech Market Analyst, noted that the last two periods when bears exceeded 50 percent were the 1994 correction and 1991 bear market. Both events proved to be excellent buying opportunities. Advisers are more bearish now, Stack said, than at any time during the dot-com crash or in the aftermath of the terrorist attacks of Sept. 11, 2001.
What happens when newsletter editors have a sunnier collective disposition? The highest ratio of bulls to bears in the past three years, about 3 to 1, was early in October 2007, almost exactly at the top of the bull market.
More evidence of severe pessimism among professionals comes from the latest Merrill Lynch monthly survey of global fund managers, released in mid-October. Commentary accompanying the results calls the survey “one of the most pessimistic we have ever conducted.”
“Over the past month, fund managers have lost faith in global growth, commodities, China’s economy and emerging markets,” it goes on to say. “By historical standards, a lot of bad news is now in the price, although the fragility of the financial system means that history may be a less reliable guide than usual.”
In the survey, 17 percent of fund managers described themselves as overweight in equities, including 2 percent who said they were “aggressively overweight.” The 62 percent who said they were underweight was the highest figure in at least a decade.
A popular sentiment indicator that relies less on what investors say and more on what they pay is the Chicago Board Options Exchange volatility index. The VIX uses the pricing of stock index options to calculate the level of market volatility anticipated over the next month.
Heightened expectations of volatility tend to coincide with uncertainty, which goes hand in hand with fear and panic. The VIX reading usually trades from 15 to 30 during placid times. Spikes above 40 often herald imminent market bottoms and have occurred at key turning points, like the depth of the Russian debt default in 1998 and the reopening of the U.S. stock markets after the Sept. 11, 2001, attacks.
The panic was so severe in October that the VIX, which had never been as high as 50 since the measure was introduced nearly 20 years ago, far exceeded that level on several days and nearly reached 90 on Oct. 24.
The VIX is one of several sentiment indicators that led John Buckingham, editor of The Prudent Speculator newsletter, to tell his subscribers that “it is far better to be a buyer than a seller today.”
“Obviously, it would not be a big surprise to see more short-term pain,” he wrote, “but it is nice to know that some of the technical data we look at are flashing a screaming short-term buy signal.”
Buckingham was also encouraged by the fact that 98 percent of the components in the Standard & Poor’s 500-stock index were trading below their 50-day moving average, which is the average closing price of each stock from the preceding 50 trading sessions.
Komal Sri-Kumar, chief global strategist at TCW Group, a Los Angeles subsidiary of the French bank Société Générale, also finds the high VIX readings “a buy signal and one more indicator that the situation is bottoming out.”
Sentiment measures are strong forecasting instruments, but they are not foolproof. Sri-Kumar cautioned that there would probably be one or more retests of the recent low before it was clear that the bear market was over.
“This is not it - we haven’t resolved it,” he said. “We are going to get out of this, but we aren’t there yet.”
One problem with sentiment measures is that once readings become extreme, they can become more extreme still. Anyone who bought stocks when the VIX hit 50 would have suffered through much of the latest plunge.
“You never know until later on whether an extreme was the extreme,” said Herrmann, Waddell & Reed chief executive. “There were lots of indicators suggesting that we were in extreme territory, but if you acted on those, you could have lost another 20 percent.”
One sign of a more secure bottom, he said, would be a retest of recent lows accompanied by sentiment readings that were somewhat less bearish. Until then, he advised investors to recall John Maynard Keynes’s Depression-era admonition: “The market can stay irrational longer than you can stay solvent.”
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