The guiding idea behind looking at sentiment is that the mass of investors is wrong.  In other words, it’s a contrary approach.  As an investment strategy, however, it can be costly to go against the majority of investors as a practice.  Instead, Ned Davis points out that the it’s at the turning points in markets, when sentiment is at an extreme, that it pays to go against the crowd.  In his book, The Triumph of Contrarian Investing, Ned says that,

A top in the market is the point of maximum optimism, and a bottom in the market is the point of maximum pessimism.

When sentiment is changing at those extremes and reverses, however, that sentiment is usually right until the next extreme.  In other words, the crowd is usually right, except at extremes.  Charles Mackay, in the 1800s, was one of the first to print an authoritative work on sentiment, The Madness of Crowds, and a quote that sticks in my memory from it is this one:

Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.

 There are many gauges of investor sentiment available.  One of the most common is from the American Association of Individual Investors (AAII).  Each week it polls its members, asking whether they’re bullish, bearish, or neutral.  Also, on a monthly basis members are asked what their asset allocation amongst cash, stocks, and bonds.  Investors Intelligence has the longest running sentiment survey, but its survey covers just investment advisors.  It, too, asks whether the respondent is bullish, bearish, or neutral.

 With the data in hand, there are a number of ways to look at it.  The simplest is to just look at the percentage in each camp.  A record number of bullish respondents tends to be bearish for the markets, while a record number of bearish respondents tends to be bullish.  The neutral category can be problematic, however, and needs to be considered in the mix.  For example, a paucity of bulls should be considered in light of the neutral camp, as this latter group tends to largely be bulls waiting for a pullback in the markets.  So, additional mathematics can be performed to allow for this, such as considering only the ratio of bulls to the total of bulls and bears.  That, in itself, won’t be helpful unless compared against that ratio over time and at turning points in markets.

Most of these surveys–and other variants–are arcane and only known and used by a few.  There are, however, a number of sentiment sources that are not often considered as such, and one was remarked on this week by the ultimate slicer and dicer of sentiment, the excellen sentimenTrader service.  He took a look at the monthly Conference Board Consumer Confidence index, which, last week, took an unexpected nose dive.

From last week’s Weekly Recap & Outlook, I had this to say about the release.

The Conference Board’s Consumer Confidence measure fell from 55.9 to 46.0, well below the expected 55.0. Like many sentiment surveys, the Conference Board’s inquires about current and future conditions. According to the group’s press release,

“Concerns about current business conditions and the job market pushed the Present Situation Index down to its lowest level in 27 years (Feb. 1983, 17.5). Consumers’ short-term outlook also took a turn for the worse, with fewer consumers anticipating an improvement in business conditions and the job market over the next six months. Consumers also remain extremely pessimistic about their income prospects.”

It turns out that big drops in Consumer Confidence from already low levels can be very good contrary buy signals.  You can see that in the chart below.  Jason considered big drops in confidence when confidence was already depressed; i.e. below 100, the dotted line below.  I’ve draw in circles on the confidence indicator (lower panel) and the corresponding levels in the S & P 500 (top panel) to help you in seeing the connection.

Finally, we believe that markets are going to be range-bound for a number of years, until about 2016, as we deal with a number of issues.  I’ve added some dashed horizontal lines to indicate what might be the trading range, and it looks like extreme lows in consumer confidence might be a good way to determine extremely atractive buying opportunities, while tidbits like this observation should give indications of when to add to positions.

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When volume does not–as technicians say–confirmthe price action, a divergence is said to have occurred. You’ve probably heard this in the context of Dow Theory, one of the oldest technical measures, which says that highs in the Dow Industrials should be confirmed by highs in the Dow Transports, with the original thinking being that if the Industrials are doing well, the transporters of the goods should be doing well since they’re shipping stuff to the ones making the stuff.

So here is a sampling of stocks from the sectors that have been the hottest since Armageddon (i.e. March 6).  Each has the same pattern:  rising prices and falling volume.  The lower volume means that fewer and fewer (and fewer?) buyers are responsible for pushing the stocks up.  Tops–of varying magnitudes–are not made of a bunch of astute sellers, but, rather, a lack of buyers.

We could be in for a bit of a pullback, but one that shouldn’t be as severe as some in the past.  Maybe the S & P 500 will drop to the 800 level before resuming the rally.  That’s just 4.6%, and that might not be worth standing aside from.

Here are the charts:

Also, the tenor of banking news has definitely gotten better–maybe too better, such that expectations have been pushed to high.  That was, perhaps, evidenced in the reaction to Goldman Sachs’ Monday night early release of earnings.  Despite doubling estimates, the stock sold off with a vengeance on Tuesday–on strong volume.

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