Investing with Sentiment Indicators – Proving that People are Idiots

Possibly one of my favorite scenes from Seinfeld is when George Costanza decides that every decision he’s ever made has been wrong, resulting in the fact that his life is the complete opposite of everything he wanted it to be. Starting with chicken salad, he resolves to do the opposite of all his instincts. Immediately, his life turns around – he finds a girl, gets a job, and moves out of his parents’ house.

This pretty much describes how a rational investor should look at the stock market. There is the famous story of how JFK’s father, Joe Kennedy Sr., knew it was a good time to exit the market in 1929 when his shoeshine boy started giving him stock tips. Bernard Baruch, another well-known stock investor of his day, said:

Taxi drivers told you what to buy. The shoeshine boy could give you a summary of the day’s financial news as he worked with rag and polish. An old beggar who regularly patrolled the street in front of my office now gave me tips and, I suppose, spent the money I and others gave him in the market. My cook had a brokerage account and followed the ticker closely. Her paper profits were quickly blown away in the gale of 1929.

Unfortunately for us, the market has a remarkable capacity to inflict the most pain on the most people when you least expect it. It is easy to buy into the market when everyone around you is also buying, but you need to take George Costanza’s advice and do the opposite of what your instincts tell you.

Let’s take a look at a few sentiment indicators and see if they live up to their promise:

1. The American Association of Individual Investors (AAII) Sentiment Indicator

First up is perhaps the most widely cited sentiment indicator – a weekly survey done by the AAII that asks its members (retail investors) how they feel the stock market will do over the next six months. Are they bullish, bearish, or neutral? You can find out at the AAII website here. If you want to chart the figures, just go here and click on the links under “Major AAII Sentiment Survey Indicators”.

The survey gets interesting when we see extreme levels of bullishness or bearishness. We are basically looking for results that are a couple of standard deviations away from the average. Typically this means around 60% bullish or 60% bearish. We all know that people are idiots, so when the majority of retail investors have conviction which way the market will go, we should think about doing the opposite.

I like this sentiment indicator as it is one of the few that actually has some academic credence. CXO Advisory (a great website with some free and premium research) found that

[…]investors may be able to exploit extreme values of AAII net investor sentiment as contrarian signals[…]

In fact, they split the AAII sentiment readings into deciles, and compared the deciles with S&P500 returns for the following 6 months. The found that when sentiment was at its most bearish decile, forward S&P500 returns were highest, at an average of around 7%. They also found that when sentiment was in the most bullish decile, forward returns were at their lowest under 1%. The second most bullish decile also performed pretty poorly, generating a little over 2% over the next two months.

All the other deciles of sentiment (i.e. when the bullish/bearish readings were not at an extreme) didn’t really correlate well with future returns.

So what’s the takeaway?

Investors can exploit AAII data more easily at extreme bullish readings than extreme bearish readings. For extreme bearish readings to be useful to the investor, they must be further outside the normal range than extreme bullish readings

What this means that with the AAII data you will end up getting more sell signals than buy signals.

2. The Citigroup Panic/Euphoria Model

A lot of banks use a proprietary index of investor sentiment to find suitable buying and selling levels. This is good because it synthesizes a lot of information for us, but bad because it can be difficult to get hold of the information on a timely basis. We are also prevented from seeing how the model may have been changed to fit the data in the past. The Citigroup Panic/Euphoria model is said to provide signals that correlate with the forward 12 month returns on the S&P500. You can find a chart of the model at the bottom of this page at Barron’s, and you’ll see that it’s fairly easy to interpret.

A quick review of the models signals show that over the recent past you would have done very well by selling when the model indicated euphoria, and buying when it indicated panic.

However, it is not this simple. According to Georg Vrba over at Advisor Perspectives, the model was changed after 2008 because it had incorrectly predicted positive market returns for 2008/2009. In his graphs we note that in the first quarter of 2008 the model had indicated panic (a buy signal) before briefly surging in May and almost indicating euphoria (a sell signal). However, according to the model at the time, you would not have initiated a sell order as the model did not quite touch the level required for it to be considered a sell signal. As a result, a strict interpreter of the rules would have been long stocks going into the massive drawdown of 2008 and 2009.

As  result of this, the originator of the model changed the interpretation of the output, such that with these new rules it would have given you a profitable sell signal in 2008. Now it’s important to be aware that the actual model has not changed. All that happened is that the interpretation of the signals has been loosened. Technically, yes, this is curve-fitting, but if you believe that there is an a priori reason to believe that sentiment indicators are capable of hinting at future returns, you should be able to look at this model as a single part of a complex puzzle that you can interpret yourself in order to manage your equity exposure.

The takeaway regarding this sentiment indicator:

A strict interpretation of the output of the Citigroup Panic/Euphoria Model could have led to losses in 2008. A loosening of the interpretation of the outputs has been made in an effort to show enhanced backtesting results.

3. The CBOE Put/Call ratio

This ratio works as a measure of investor sentiment because when investors buy a lot of puts we can assume that they are fairly bearish; and when they buy a lot of calls we can assume they are fairly bullish.

What this means is that if the put call ratio is above 1, it means that more puts are being traded than calls, so the majority of people think the market will go down (or at least the people with the majority of the money think the market will go down). On the other hand, If the put call ratio is below 1, it means that more calls are being traded than puts, so the majority of people think the market will go up (or at least the people with the majority of the money think the market will go up).

Your option broker will provide you with put/call ratios that are provided by CBOE (Chicago Board Options Exchange). If you don’t yet have a broker you can always use www.stockcharts.com, which provides charts for the three most commonly used put/call ratios. These are the equity put/call ratio ($CPCE on stockcharts.com), the index put/call ratio ($CPCI on stockcharts.com), the the total put/call ratio ($CPC on stockcharts.com).

I prefer to use the CBOE total put/call ratio, smoothed out by a moving average. The chart below shows a 50-day smoothed put/call ratio (in blue) and the S&P 500 price (in black), courtesy of www.stockcharts.com. Take a look and you’ll find that when the ratio is high it is a good buying point, and when the ratio is low it is a good selling point. Of course, it is difficult to know in advance if the ratio has already hit an extreme, or if it is going to continue in the same direction, so it is always good to use it in conjunction with other indicators.

put-call-ratio as sentiment indicator

Unfortunately, the researchers at CXO Advisory crunched the numbers and found that the put/call ratio has very little predictive ability. Now I’d like to think that this is because of unfortunate sampling – the data they use for the put/call ratio is exceptionally noisy, and on a daily basis it swings about wildly. With a moving average of the ratio I believe they would have found a much higher correlation.

 


 

So there you have it, three sentiment indicators that’ll help you find a girl, get a job, and move out of your parents’ house. In a future post we’ll take a look at how VIX can be a great indicator, and why it’s doubly good for those of us interested in options trading.