When I first entered the investment publishing industry it was with Schaeffer’s Investment Research in Cincinnati. That was in September 2000 and one of the first things that I learned was about using sentiment analysis as a major part of the overall analysis. I was already enamored with the market and had been studying and analyzing it for approximately 15 years before I started working at Schaeffer’s. Up to that point, all of my analysis was based on fundamentals and technical analysis. Sentiment was the third leg to the stool.
The founder of the company, Bernie Schaeffer, used sentiment from a contrarian perspective. As I learned more and more about sentiment analysis, I implemented it more and more in my own analysis. I found a great deal of value in knowing whether the masses were bullish or bearish and to what extreme. I had watched for years as a company would drop even though it had strong fundamentals and solid-looking chart. I started to learn that it wasn’t enough if everyone was already bullish on the stock—there weren’t any buyers left to drive the stock price higher.
There are a number of tools investors can use to evaluate how bullish or bearish investors and analysts are toward a stock. Indicators like overall analysts’ ratings, short interest ratios, and put/call ratios are three of my favorites. When it comes to the overall market, the indicators become a little trickier. There are overall sentiment indicators like the Investors Intelligence Bull/Bear ratio and the American Association of Individual Investors (AAII) Sentiment survey. But one of the ones that Bernie used was newspaper and magazine headlines. He even had an intern scan magazine covers into a database, magazine covers from investment publications as well as the rare cover story on the market from magazines like Newsweek and Time.
The theory was that when the market was doing something that garnered attention from mainstream media sources, it was probably a sign that the market was getting ready to reverse course. For instance, in early 2000, there were several mainstream magazines that featured covers about internet stocks and the dot.com boom. We all know now how that craze came to a screeching halt later that year.
Another aspect of reading the sentiment is trying to figure out if there is an overwhelming consensus about the market. If the vast majority of experts are bullish or extremely bullish, this is probably a bad sign for the market. If the vast majority is bearish, it’s probably a good sign that the market is heading higher. This isn’t a case of believing you know more than the next person—it is a case of using the power of numbers, so to speak. Look at it this way, if everyone interested in buying Microsoft stock has already bought it, who is left on the sidelines to buy it? No one. If there aren’t any buyers left, it only leaves sellers and when there are sellers and no buyers, the price is going to fall. It is the basic principle of supply and demand.
This leads me to what I see happening right now. Over the last few days, I have read several headlines about various experts predicting crashes in the market. I have listened to numerous experts on Bloomberg interviews that are bearish or cautious. They are shaking their heads at how the market can keep going up with the backdrop of civil unrest and the ongoing fight against the COVID-19 virus.
I know I have voiced concerns that the market and reality have become detached from one another in the last few months, I won’t deny that. The S&P is now almost 40% higher than it was at its low in March and that is amazing to me. But the more I hear about experts and analysts being bearish, the more I have to believe that the bounce-back rally isn’t over yet.
Looking at the two overall sentiment indicators that I mentioned earlier, we aren’t at extreme readings yet. The Investors Intelligence Bull/Bear ratio is currently at 2.12 and that’s after reaching a low of 0.72 in March. Yes, it’s troubling that it has nearly tripled in just a few months, but the 3.0 level has traditionally been the level where you start to worry about excessive bullish sentiment.
The AAII Sentiment Survey paints an entirely different picture. The bullish percentage is currently at 33.1% and the bearish percentage is at 42.1% with 24.8% being neutral. Historically it is when the bullish percentage is twice as high as the bearish percentage that you should worry about excessive bullishness. Right now the ratio of bulls to bears is 0.79. This indicator has a long way to go before it signals that there could be trouble.
Don’t get me wrong, we could see civil unrest continue to grow and this could upset the financial markets at some point. There are also geopolitical concerns currently and those could change with the flip of a switch and drive the market lower. But with the sentiment readings being what they are currently, it seems like a move higher is more likely than a crash. I track these indicators on a weekly basis and if things should change drastically, I will try to let Bull Market Rodeo readers know when they reach troubling levels again.