Kirkpatrick and Dahlquist, CMT2 Chapter 7

Part II: Markets and Market Indicators
Chapter 7: Sentiment

• Chapter Objectives
  • Understand what the term “sentiment” means
  • Understand the concept of contrary opinion
  • Be familiar with methods for measuring sentiment of uninformed and informed market players
• Intro
  • Market sentiment
    • the psychology or emotions of market participants
    • investor psychology
      • Fear, pessimism
      • hope, overconfidence, greed
  • What is Sentiment?
    • Theory of Contrarian Investing
  • Market Players and Sentiment
    • Neurochemistry Effect on Human Thinking
  • How Does Human Bias Affect Decision Making
    • Investors Are Their Own Worst Enemies
      • Buy low sell high – seldom happens
      • Beating the market is almost impossible to do, but yet almost everyone thinks he can do it
      • Everyone knows panic selling is a bad idea, but it’s observed very often after earnings reports
      • Everyone knows that Wall Street strategists can’t predict what the market is about to do, but investors still hang on every word from the financial pundits who prognosticate on TV
      • Everyone knows that chasing hot stocks or mutual funds is a bad idea yet millions of investors do it.
      • Our brains drive us to do things that make no logical sense– but make perfect emotional sense.
    • Crowd behavior
      • People tend to conform to their group
      • The taking of an opposite opinion is sometimes difficult and dangerous
      • People do not like rejection or ridicule and will stay quiet to avoid such pressure
      • People often meet hostility when going against a crowd
      • People gain confidence by extrapolating past trends, even when doing so is irrational, so they tend to switch their opinions slowly.
      • People feel secure in accepting the opinions of others, especially “experts” and tent to believe the establishment will take care of them.
    • Why is is important to understand that investor emotion and bias affect investment decisions?
      • Helps technical analyst profit by spotting market extremes
      • Technical analysts must remember that they are subject to the same human biases as other investors
        • human biases are so strong that even those who recognize them still are affected by them and must constantly fight against them
        • Must be certain not to “see” patterns that do not really exist.
      • Crashes
        • panics
      • Bubbles
        • Part of the non-randomness discussed in Chapter 4: “The Technical Analysis Controversy.”
        • Bubbles occur infrequently, but more than would be expected in an ideal random walk model.
      • Books on the History of Manias and Panics (links might be to newer editions)
        • Ahamed, Liaquat. Lords of Finance: The Bankers Who Broke the World. New York, NY: Penguin, 2009.
        • Allen, Fredrick Lewis. Only Yesterday. New York, NY: First Perennial Classics, 2000.
        • Amyx, Jennifer. Japan’s Financial Crisis: Institutional Rigidity and Reluctant Change. Princeton, NJ: Princeton University Press, 2004.
        • Bruner, Robert F. and Sean D. Carr. The Panic of 1907: Lessons Learned from the Market’s Perfect Storm. New York, NY: John Wiley & Sons, Inc., 2009.
        • Galbraith, John K. A Short History of Financial Euphoria. New York, NY: Penguin House, 1994.
        • Kindlelberger, Charles P. Manias, Panics, and Crashes: A History of Financial Crises. New York, NY: John Wiley & Sons, Inc., 2005.
        • Mackay, Charles. Extraordinary Popular Delusions and the Madness of Crowds. Petersfield, Hampshire, UK: Harriman House, 2003.
        • Reinhard, Carmen M. and Kenneth Rogoff. This Time is Different: Eight Centuries of Financial Folly. Princeton, NJ: Princeton University Press, 2009.
        • Sobel, Robert. Panic on Wall Street: A History of America’s Financial Disasters. New York, NY: Macmillan, 1968.
        • Wicker, Elmus. Banking Panics of the Guilded Age. UK: Cambridge University Press, 2008.
• Crowd Behavior and the Concept of Contrary Opinion
  • Sameness of thinking is a natural attribute.  So it takes practice to get into the habit of throwing your mind into directions that are opposite to the obvious.
  • Obvious thinking: or thinking the same way everyone else is thinking, commonly leads to wrong judgements and conclusions.
  • When everyone thinks alike, everyone is likely to be wrong.  (Neill, 1997, p1.)
  • When individuals think by themselves, they can be very logical and reasonable, but when joined with a crowd, they tend to let certain cognitive biases affect their decision making.
  • The problem with implementing a contrarian strategy:
    • Prices trend (Dow Theory)
    • When prices trend upward we want to be in a long position, riding the trend
    • The goal of understanding sentiment is to discern when that trend is losing energy and will reverse.
    • Find a way in which to quantify which direction the majority of market players is headed and to question whether there is enough remaining energy to keep the market moving in that direction.
    • As long as players still have money to invest in the market, their optimism will drive prices higher.
    • It is only when players are fully invested that their optimism will not be accompanied by security purchases.
    • At this point, the market is at an excess, and the trend often ends.
    • To quantify these excesses, the technical analyst uses publicly available data to construct indicators of emotional excess.
• How Is Sentiment of Uninformed Players Measured?
  • Intro
  • Sentiment Indicators Based on Options and Volatility
  • Option Trading and Sentiment
  • Using Put/Call Ratios to Gauge Sentiment
    • ISE Sentiment Index and the S&P 500
    • Combining put/call ratios with futures premium to gauge sentiment
  • Volatility and Sentiment
  • Using Volatility to Measure Sentiment
    • The S&P 500 and VIX
  • Combining Put/Call Ratio and Volatility
  • Polls
  • Advisory Opinion
    • Advisory opinion– Percentage bullish/[percentage bullish + percentage bearish]
    • Advisory opinion with monetary component
  • American Association of Individual Investors
    • American Association of Individual Investors bulls and bears
  • Consensus Bullish Sentiment Index
  • Market Value
  • The Sentix Sentiment Index
  • Consumer Confidence Index
    • The Consumer Confidence Index (1967-2010)
  • Other Measures of Contrary Opinion
  • Buying and Selling Climaxes
  • Mutual Fund Statistics
  • Mutual Fund Cash as a Percentage of Assets
    • The mutual fund cash/assets ratio appears to be only a marginal indicator of uninformed sentiment
  • Rydex Funds
  • Marginal Balances
    • When uninformed investors are most optimistic, they have placed most of their capital in the market and may buy stocks on margin to leverage their position.
    • But more recently, margin debt reflects professional speculators and might not be as useful as before.
    • Taking away more usefulness from margin debt for forecasting is the ability through derivatives of holding positions outside the requirements for margin, which apply to banks.
  • Money Market Fund Assets
  • Relative Volume
  • Uninformed Short Selling
  • Odd-Lot Short-Selling
  • Unquantifiable Contrary Indicators
    • Eccentric Sentiment Indicators
  • Historical Indicators
  • How is the Sentiment of Informed Players Measured?
  • Insiders
  • Sell/Buy Ratio
  • Investors Intelligence Method
  • Secondary Offerings
  • Large Blocks
  • Commitment of Traders (COT) Reports
• Sentiment in Other Markets
  • Treasury Bond Futures Put/Call Ratio
  • Treasury Bond COT Data
  • Treasury Bond Primary Dealer Positions
  • T-Bill Rate Expectations by Money Market Fund Managers
  • Hulbert Gold Sentiment Index
• Conclusion
• Review Questions