Break Away--and Cash In

When the herd is running one way, you may profit by running the other. Here's how to read the market's mood swings

On Mar. 12, the stock market abruptly switched directions and rose 7% in the following three sessions. The powerful rally may have surprised many investors -- but certainly not those who believe in sentiment indicators.

Second in a Series
In the days leading up to the market's about-face, fans of this contrarian strategy found mounting evidence that investors were overly gloomy. Lowrisk.com's weekly poll of visitors to its Web site, which caters to traders, showed 69% bearish -- the second most negative reading in its six-year history. Similarly, Merrill Lynch's (MER ) Short-Term Sentiment Index, made up of several other investor polls, flashed one of its most negative readings of the bear market. Elsewhere, investors continued to yank their money out of U.S. equity funds, to the tune of $1.4 billion during the first week of March, marking the seventh straight week of redemptions.

What should you do when you see these and other signs that the crowd is moving too far in one direction? Your strategy is to swim against the tide -- buying stocks, say, when fellow investors are bluest. Inevitably, a stock market that has been stretched too far in one direction will snap back, allowing you to profit ahead of the pack.

THE RIGHT MOMENT. Sentiment indicators are based on the idea that investors, as a whole, exhibit manic behavior: When they're most fearful, the market is hitting bottom; when they're overly giddy, the market is near a peak. By tracking mood swings, you can get a sense of when the stock market is likely to rally or dive. "They can be a useful tool for timing the market," says Rick Bensignor, chief technical strategist at Morgan Stanley (MWD ).

In this installment of Market Measures, a continuing series on analytical tools to help you hone your investing skills, we'll tell you about some key investment-sentiment indicators and how to interpret them.

Sentiment indicators don't all move in tandem. What you're looking for is a clump of them with extreme readings, either positive or negative. Why? It's only when investors become one-sided that the prevailing market trend is likely to reverse. Psychology plays a role in the phenomenon, but money is a bigger factor. "Overly gloomy investors hoard cash, which gives them plenty of buying power when their mood turns," explains Bensignor. Conversely, bull markets lose steam when investors have spent all their money and thus lack the means to propel prices higher.

You can divide sentiment indicators into two groups: They measure either what investors do or what they say. The first category follows the money, tracking mutual-fund flows, short-selling activity, and options trading. The second category includes investor polls that monitor bullish and bearish outlooks.

Indicators that examine what investors are doing on a daily basis offer the most up-to-date information. In this category, a closely watched indicator is the Volatility Index (VIX) of the Chicago Board Options Exchange (CBOE). When the index goes up, as it has generally been doing during the past several months, it means that investors are willing to pay higher prices to buy options on the Standard & Poor's 100-stock index. (The option holders have the right to buy or sell a stock at a particular price in the following two months.) "It's an indication of how much investors are willing to pay for portfolio insurance," says Thomas McManus, chief equity strategist at Banc of America Securities (BAC ).

When investors are more fearful, the index goes higher. Recently, the VIX stood at 36. What would signal excessive pessimism? Wall Street analysts say the VIX would need to surge to 45 to 50. On Oct. 10, for instance, when the Dow Jones industrial average fell to its lowest level of the bear market, the VIX went as high as 50. You can find the VIX on the CBOE's Web site, www.cboe.com.

Another useful indicator you can find at the same site is the CBOE's put-call ratio. Put options give the buyer the right to sell a stock at a specific price for a defined period of time. Call options give the buyer the right to buy a stock at a particular price for a specific period of time. When put options dominate, investors are betting that stocks are more likely to fall than rise.

Because the put-call ratio can be volatile on a daily basis, Wall Street pros like to use a 10-day "moving average," which is calculated every day from the put-call ratio of the most recent two weeks. A reading above 1 (more than one put option for every call option) means investors are excessively pessimistic. Conversely, a reading below 0.6 (or 0.6 puts for every call) is a sign that investors are getting too bullish.

HOW GRIM? Recently, the 10-day average put-call ratio stood at 0.81, which means, by that measure, investors aren't excessively bearish. In September, by contrast, the ratio got as high as 1.03. At the height of the bull market in March, 2000, the ratio registered a mere 0.42.

In the opinion-poll category, Investors Intelligence's survey of investment newsletter editors commands the most respect, in part because it has been around for 40 years. Each week, Investors Intelligence asks 130 editors whether they are bullish or bearish. Over the past three months, the proportions of generally bearish advisers has gradually swelled; it recently stood at 38%. While that's a sign that investors are becoming more glum, Walter Murphy, senior international market analyst at Merrill Lynch, says he would have to see the poll's bearish percentage jump to 45% to suggest there was excessive pessimism.

Also widely watched is Market Vane Bullish Consensus, which polls stock-index futures investment advisers. In the latest weekly poll, 21% were bullish, the smallest amount in seven months. Murphy considers any reading below 25% bullish to signal strong pessimism.

Another key opinion poll focuses on members of the American Association of Individual Investors. In the Mar. 13 weekly survey, 51% of those questioned were bearish, up from 39% the previous week. Wall Streeters consider a reading of more than 45% bearish to be extremely negative. The AAII shows the poll's results at aaii.com, but you must be a subscriber to access the data.

Reading sentiment indicators is as much art as science. Look at them collectively and in tandem with other factors that affect the stock market. Their biggest value may be in reminding you how easy -- and foolish -- it is to get caught up in the pack mentality.

By Susan Scherreik

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