(This is the second of a two-part series on investor psychology).
There are number of different psychological indicators that investors can use to gauge the market.
The short interest ratio: In the stock market, there are those who believe that it will go up (the bulls) and those who think that it will go down (the bears). The bears may often sell short, that is make a bet that the market will go down. Selling short is a technique that allows an investor to make money when a stock goes down by first selling the stock and buying it later at a lower price. The NYSE and other exchanges keep track of how much short selling is being done. They publish this information as the short interest ratio. Typically, since the “crowd is wrong,” when there are a lot of short sellers around and the ratio is high (around six) the market most often goes the opposite way, climbing higher. Conversely, when the ratio is low (around one) the market will turn and go down.
Bullish versus bearish sentiment: Investors Intelligence publishes a newsletter that surveys advisory services. Typically, the majority of advisory firms are wrong at market extremes. When the trend is up, they are bullish and when the trend is down they are bearish. This indicator is a very good contrary indicator.
Odd-lot short sales: Usually people buy stocks in round lots, 100 shares even. However, smaller investors often trade in odd-lots, that is, 75 shares. These odd-lotters who engage in short selling are viewed as the most naive investors of all. Thus, the odd-lot short sale index, which measures the total odd-lot sales that are short sales, is one of the best gauges of current market psychology. The higher the percent — meaning the more that odd lot short sellers are involved in the market — the better the odds that the market is headed higher, and vice versa.
Specialist short sale ratio: Just as the behavior of the general investor is important, measuring professional market behavior is equally important. Specialists (now known as designated market makers), those on the floor of the NYSE charged with “maintaining a fair and orderly market” in individual stocks they are assigned to, can be measured. Since they are at the heart of the market they are considered very savvy in their investing. Published figures give a good idea how much specialists are shorting the market compared to general investors. Typically, when specialists are short a lot of stock versus the public, the market goes down, and vice-versa.
Puts versus calls: Option buyers are another group of investors who are often wrong. These traders shoot for large, highly leveraged profits. In return, they risk heavy loss of capital. The sentiment of such extreme risk-takers often yields valuable clues to future market behavior. These investors buy put options when they think the market is going to go down and they buy call options when they think it is going to go up. They are often wrong, especially during extreme call buying or put buying times. Therefore, a high ratio of puts to calls usually precedes a period of rising prices, not falling prices as the option speculators would prefer. Conversely, a low put-call ratio (indicating relatively little put-buying and greater call-buying) is usually followed by declining prices.
The above “psychological indicators” are the most used ones. However, the mutual fund share purchases and redemptions figures, the OTC versus NYSE volume and the number of stock splits are other indicators that are used in combination with the above to gauge the psychology of the market.
Like all market tools, psychological indicators have generally reliable signs to indicate future market direction. However, they need to be used carefully and methodically, as there are no absolute rules that work all of the time.
Quote of the Week: “No one can disgrace us but ourselves.” __JG Holland
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.