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Buying Stocks Based on How Other People Feel

Barry Ritholtz is a Bloomberg View columnist. He founded Ritholtz Wealth Management and was chief executive and director of equity research at FusionIQ, a quantitative research firm. He blogs at the Big Picture and is the author of “Bailout Nation: How Greed and Easy Money Corrupted Wall Street and Shook the World Economy.”
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One of my favorite pastimes is dissecting accepted Wall Street wisdom to see if it contains any value for investors or traders. Often, upon examination, the widely held beliefs turn out to be closer to magical thinking than financial acumen.

One of the more recent examples is the way some analysts use data on sentiment to determine how much an investor should allocate to equities. The problem is that the sentiment data is inconclusive and sometimes contradictory. There is no signal within the noisy data.

Sentiment is extremely difficult to use as an indicator because it is only rarely at the extreme readings needed to generate a reliable trading signal. Recall the March 2009 low, where every measure of sentiment was deep in the red. Or October 2002, by which time the Nasdaq Composite Index had fallen almost 80 percent from its high and everyone hated tech stocks. These extreme events are rare.

One of the analysts who has observed these phenomena for many decades is Laszlo Birinyi, formerly of Salomon Brothers, and now ofBirinyi Associates. In this weekend’sMasters in Business interview, Birinyi describes why so many sentiment measures are worthless. There is no usable signal in the American Association of Individual Investors bull/bear survey, Birinyi says. Many other such polls also lack a consistent methodology or are otherwise flawed. They are useless to investors, he says.

Lately, I have been seeing a spate of articles and blog posts that try to make the claim otherwise. Many of these are either inconsistent in their understanding of sentiment or misstate the significance.

ZeroHedge is one such site. Known for its insightful analysis of derivatives and flash trading, its ventures into sentiment readings have been less successful during the course of the 200 percent rally in the Standard & Poor's 500 Index. But one recent post on the site contained a surprisingly bullish subtext. A post headlined“CNBC Viewership Plunges To 21 Year Lows” shed light on the persistent apathy of individual investors toward equities. High levels of investor attention to financial media often accompany market bubbles -- or crises.

Data confirm this lack of enthusiasm. The Federal Reserve’s Survey of Consumer Finance found that “only 48.8 percent of Americans held stock either directly or indirectly in 2012.” According to CNBC, this is the lowest level since 1995. The Wall Street Journal also noted that mutual fund investors were “stepping back” from U.S. equities.

There is lots of anecdotal evidence that suggests the markets have become too frothy and that sentiment has become too bullish. Lately, many bears who fought the tape the entire way up have abandoned the cause. As the Journal's blog Moneybeat reported, Gina Martin Adams, senior analyst at Wells Fargo Securities, threw in the bearish towel. This was months after Morgan Stanley’s Adam Parker capitulated. And longtime bear David Rosenberg famously turned bullish more than two years ago.

However, as the old saw goes, the plural of anecdote is not data. Until we can quantify what various strategists who have missed a huge rally turning bullish actually means to future market action, it's best to take all sentiment data with many grains of salt. No one has the ability to consistently forecast any of the inevitable market corrections (despite being told the trick). Instead, I have found it best to ignore the short-term action and concentrate on being on the right side of the long-term trend.

Rest assured, as soon those extremes in sentiment appear, you will be reading about them in this space.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Barry L Ritholtz at britholtz3@bloomberg.net

To contact the editor on this story:
James Greiff at jgreiff@bloomberg.net