One of the best ways to assess conventional wisdom is by surveying the opinions of those who publish newsletters advising subscribers on market direction, stocks to buy and sell, and so forth.
One advisory service, Investors Intelligence, publishes a newsletter that surveys 140 advisory services that put out market letters. This survey is printed in many traditional and non-traditional financial publications. When the survey began in 1963, it was thought that advisory services would pick market tops and bottoms quite well. But to the surprise of some, including the staff at Investors Intelligence, it turned out to be just the opposite.
They found that investment advisory firms, taken as a group, are wrong most of the time mainly because they are trend-followers. When the trend is up, they are bullish (positive about the market) and advise their clients to be in the market. When the trend is down, their advice is bearish (negative about the market). So, a contrary theory prevailed: Peaks in bullishness or bearishness generally come before the market tops or bottoms, rather than being coincidental. In bull markets, moreover, corrections end quickly and tops take longer.
When the number of bullish advisers in Investors Intelligence’s survey tops 54 percent and bears dip below 20 percent, it’s time to expect a drop in the market. This happened in January 1992, when the bullish number peaked at 60 percent. The market itself peaked a few days later. The same was true during the last phase of Dotcom Bubble and the 2008 market top.
When waiting for the market to complete a correction, watch for the number of bullish advisers to shrink below 40 percent and the bears to increase to 30 percent or more. At that point, a rally can be expected. In a general bear market the percentage of bearish advisers needs to climb to 55 or 60 percent before a bottom is reached and an upturn can be expected.
When the market was bottoming in 1982, the Investors Intelligence’s indicator was 62 percent bearish. The final low was made that August. The Dow then surged several hundred points before a majority of the advisory services realized that what was happening was the beginning of a bull market that turned into the great bull run of the 1980s.
Sentiment indicators measure the expectations of participants in the market. These participants can be broken down to include individual investors, corporate insiders, stock exchange members, mutual funds, institutional traders, floor traders and as I said above, newsletter advisory services.
These sentiment indicators are actually measuring the emotions of these participants. As is the case with most things in life, emotions change. They swing back and forth. Sentiment indicators swing back and forth between extremely bearish to extremely bullish.
The majority of investors are usually most optimistic at a market top and most pessimistic at a market bottom. The more optimistic or pessimistic the majority is, generally, the more significant the top or bottom is. Just think back to the heady days of the last stages of the Dotcom Bubble.
Why does this happen? It’s nice to believe that we are all smarter than the generation before us, especially because of the heavy use of computers, instant information and modern day science. The fact is, markets are and have been driven mostly by emotion. All of these modern day tools cannot overcome the emotional push and pull affecting us from consistently rising or declining prices. Longtime investment advisor Richard Ney put it this way, “Rising prices pull investors into the market like iron filings to a magnet.”
The famous investor Richard Russell said this about what happens during a bull market top, “Worthless equities were being sky-rocketed without regard for intrinsic worth or earning power. The whole country appeared insane on the subject of stock speculation. Veteran traders look back at those months and wonder how they could have become so inculcated with the ‘new era’ view as to have been caught in the inevitable crash.” What he is talking about is psychology and how the power of price takes over from logic. And as Investor’s Intelligence suggests, professionals are not immune.
Quote of the Week: “Government is a trust, and the officers of the government are trustees; and both the trust and the trustees are created for the benefit of the people.” — Henry Clay
Bart Ward is the chief executive officer of Ward & Co. Ltd., an Anoka-based registered investment adviser – specializing in the management of stock and bond portfolios in companies which are listed on the NYSE.