00
3.62 10/26/95
8.29
20.6
28.7
5/13/99
13.7 10/26/95
26.4 11/22/95
9/23/99
5.63 10/15/9920.2
3/7/00
1.63% 2.44% 10/26/95 1.28% 1/14/00 1.74% 10/15/99 1.28%
1/14/00
Psychological Market Indicators (Source: Investor’s Business Daily, September
majority of investors have bearish stock positions. From a contrarian perspective,the existence of too many bears brings in the bulls. If the selling strength is playedout, buyers may rush in to buoy the market back up. The easiest way to understandthis is by applying the law of supply and demand. Heavy put buying is a sign ofbearish market bias, while heavy call buying denotes bullish sentiment. However,many professional traders believe that option buyers are usually wrong and apply acontrarian approach to interpret put/call ratios (i.e., if the put/call ratio is high, thecontrarian investor takes this as a bullish sign of market strength).
Mutual Fund Share Purchases/RedemptionsMutual funds are some of the largest players in the stock market. Their size makesthem an important sector of sentiment analysis. Analysts study mutual funds by
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monitoring their cash reserves and tracking their purchase and redemption performance. The IBD’s fund purchase-redemption ratio compares mutual fund purchasesto redemptions. If the ratio of purchases are higher than redemptions, then the fundsare cash rich and the general market should be bullish. If there are more redemptions than purchases, then the funds are cash poor and a bearish trend may be developing in the general market.But the contrarians are always just around the corner. Net redemptions would indicate the general population is feeling pessimistic about the market; and at its extreme measurements, this would be considered a contrarian indicator—that is,bullish. A net purchase paints the opposite picture. When it’s at extreme levels on anhistorical basis, this is a bearish sign (too much optimism).Institutional investors can also be easily tracked by monitoring a streaming quotescreen—specifically watching a stock’s TSize values which tells you the number ofshares in the last trade. TSize is important because a stock moves when an institutionor someone who’s buying big volume or selling big volume is coming into the marketplace. If you see a stock and it’s trading only 100-share lots, there are no reallybig players in there, so don’t expect those stocks to move. You’re not going to makea lot of money from those. You have to keep an eye out for block trades—typicallydefined as 5,000 shares traded at one time. If you start seeing a number of 5,000,10,000, 15,000 blocks, then you know there are probably some big players who aregoing to move the market. They’re the ones who are going to help you make money.
Nasdaq Daily Trading Volume as % of NYSE Daily VolumeSince the Nasdaq is generally believed to hold more small-cap issues, an increase ofNasdaq volume (more activity in smaller issues), is a typical sign of a late-stage bullmarket—another way of saying that the party’s almost over.
Number of Stock Splits in Investor’s Business Daily 6,000(Prior 30 Days)If the price of a stock rises too high, investors may become wary of investing in it.Many times, companies will choose to orchestrate a stock split to reduce the price.If a stock is selling for $200 a share, they may choose to do a 2:1 stock split, reducing the price of the stock to $100 a share. So if you own 500 shares of a stock at$200 per share before the split, you’ll own 1,000 shares of the stock at $100 pershare after the split. The market value of the total number of shares remains thesame, but the number of the corporation’s outstanding shares increases while theprice of its stock decreases.Since stocks split when their prices reach higher levels, an increase would naturally mean higher prices overall, and is a caution sign at best, and a bearish signalat worst.
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New Issues in Last Year as % of All Stocks on NYSENew issues come to market when the getting’s good—definitely a bullish sign. Whowants to seek public financing when the market conditions are poor?
Price-to-Book Value Ratio of Dow Jones Industrial AverageBook value is an accounting term used to measure a firm’s assets relative to its liabilities. A price-to-book (P/B) ratio is calculated by dividing a company’s stock priceby its book value. Generally, value investors look for stocks with low price-to-bookratios. Market watchers also follow the price-to-book value of the major averages.The price-to-book ratio of the Dow Jones Industrial Average is the (price-weighted)average P/B of the 30 stocks within the Dow Jones Industrial Average.If you could buy a dollar for fifty cents, it would be a good deal, right? If a dollarcost $1.50, that’s a bad deal. A higher ratio is an indicator of a higher stock price,and is not a sign the Dow Industrials are selling at a cheap price.
Price-to-Earnings (P/E) Ratio of Dow Jones Industrial AveragePrice-to-earnings, or P/E, is a company’s stock price divided by earnings over thepast 12 months. The price-to-earnings ratio of the Dow Jones Industrial Average isthe (price-weighted) average P/E of the 30 stocks within the Dow Jones IndustrialAverage. Higher P/E ratios mean an investor is paying up for earnings. High is bad,and low is good.
Current Dividend Yield of Dow Jones Industrial AverageDividend yield is the annual dividends of a company divided by its stock price. If,for example, a company pays a $4 annual dividend and the stock price is $50, thedividend yield equals $4 / $50 or 8%. The current dividend yield of the Dow JonesIndustrial Average is the annual yield from dividends of the 30 stocks in the DowJones Industrial Average if they were purchased at that time. Imagine a teeter-totter;one end is the stock price and the other is the dividend. The higher the yield, thelower the stock price. High yields are a sign of pessimism.
GRAPHIC DISPLAYS OF PSYCHOLOGICAL INDICATORS IN IBDThe IBD also features a number of excellent graphs that can help investors gauge overall market performance. Let’s take a look at some of these clues to market sentiment.
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Investment Advisers Bullish and BearishAnother way to track market sentiment is to survey the opinions of professional advisers. A person can track, in easy-to-read graph form, the percentage of adviserswho are bullish and bearish. IBD even goes one step further, indicating the overallpercentages would tend to indicate sentiment one way or the other. At the risk of repetition, these would be considered contrarian indicators. (IBD even tells you that!)
Short Interest RatioShort interest ratio is a popular indicator that helps to gauge negative investment sentiment. Shorting a stock is a bearish strategy that involves borrowing shares from abroker in order to receive a credit from their sale. If the price declines, the seller canbuy the shares back at a lower price to cover the short and pocket the difference. Theshort interest ratio indicates the number of trading days required to repurchase all ofthe shares that have been sold short. A short interest ratio of 1.50 would tell us that,based on the current volume of trading; it would take one and a half days’ volume tocover all shorts. Again, using a contrarian view, a high short-interest ratio is usually asign of a bullish market, while a low short-interest ratio is generally a sign of a bearish market. This is contrarian for two reasons. The first reason is standard, the “Ifeveryone is bearish they must be wrong” analysis from before. The second reason ismore subtle, but quite clever: If the short sellers are indeed wrong, and the market iseven just neutral or slightly bullish, the short sellers will have to cover their shorts(buy back the stock they have shorted), putting strong buying pressure on the marketjust as it starts up. This will lead to a multiplying effect to the upside.
Odd-Lot Short SellersAn odd lot represents any number of stock shares less than 100. Small investors wholack the capital to purchase a round-lot order of 100 shares usually buy odd lots.Hence, odd-lot investors have limited experience and are often wrong. A contrarianinterpretation of odd-lot short sales is an excellent method of gauging market sentiment. Basic odd-lot psychology assumes that an increase in odd-lot short sales translates as a bullish indicator and a decrease in odd-lot short sales is a bearish indicator.
Odd-lot short sales: The total number of shares sold short in odd lots during amonth. In other words, the number of shares sold short in quantities of less than100 shares. Since investors trading in odd lots are considered less sophisticated,a large number of odd-lot short sales is interpreted as a bullish sign, while a lownumber is a bearish sign for the market.
ADDITIONAL SENTIMENT INDICATORS
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Option Trading VolumeNot to belabor the obvious, but put buyers are typically bearish on a stock, whilecall buyers are bullish. A comparison of the number of open contracts between thesetwo camps will provide a clue as to how people really feel, and can thereby providean overall sentiment analysis tool.When put buying becomes rampant, the majority of people are convinced thestock or index is heading lower. When there’s a lopsided proportion of call buyersto put buyers, optimism reigns supreme. A very high percentage of option contracts expire worthless every month, indicating that the majority of optionstraders are buying at the wrong time. The put/call ratio is a beacon that alerts theastute trader to sentiment extremes—the concentrations of buyers doing thewrong thing. Whenever you see this type of extreme, say to yourself: “The crowdis always wrong.”Put/call ratios are not usually spelled out in detail for the trader; they’re forced tofigure it out for themselves. (The CBOE provides it for you; go to www.cboe.com.)To calculate it, divide the number of puts by the number of calls. In short, the further the OEX put/call ratio is below 1.00, the more bearish it is; between 1.00 and1.25 is neutral, and above 1.25 is bullish.
Option Open InterestOpen interest reveals the current number of outstanding option contracts that areavailable in a specific option series by the end of a trading day. Hence, monitoring the open interest of an option enables traders to track the demand of anoption. A rise in an option’s open interest means there are additional buyers forthe option. Conversely, a decline in the open interest of an option indicates lessbuyers and more sellers than before. However, comparing the open interest of acall option to the open interest of a put option (with the same strike price and expiration) is a psychological indication of the underlying stock’s bullish or bearish bias.For example, if the open interest in the November 75 calls for Intel (INTC) is15.1K, then 15,100 contracts have been initiated. If the open interest for November75 puts is 12.3K, a bullish trend is confirmed. However, to forecast a directionalchange in the market, it is important to monitor the daily fluctuation of open interest. Since small options investors are consistently on the wrong side of a rally, anabnormal rise or decline in the open interest of puts and/or calls often signals achange in directional bias. Generally speaking, an abnormal rise or decline in openinterest once again sends a contrarian signal to the sentiment investor. However,traders must be careful since sometimes a large increase in open interest may onlybe a large trader or institution hedging a position.
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Mutual Fund Sales and RedemptionsThe emergence of mutual funds has begun providing useful information as to market sentiment. On-balance volumes (inflow versus redemptions) indicate whetherthese mutual fund managers will be buying or selling, in simplistic terms. Massiveinfluxes of cash is a strong bullish indicator, the opposite holding true if investorsare predominant sellers. This measurement is tough to come by, short of waiting forthe media to report it. If you have the inclination and the means, TrimTabs.com(www.trimtabs.com) offers it for a price, although a 30-day free trial is available.
Margin DebtAnother measure of investor sentiment is reflected in the amount of money individuals have been borrowing from their brokers to buy stocks. Margin accounts arebrokerage accounts that allow investors to purchase securities on credit and to borrow on securities already in the account. When investors are excessively bullish onthe market, margin debt will increase. Therefore, as a contrarian indicator, higherlevels of margin debt are seen as a negative for the market. Margin debt levels arereported monthly in the Wall Street Journal:Margin Debt Falls in July, Following Increase in JuneA WSJ.COM News RoundupNEW YORK—Margin debt at member firms of the New York Stock Exchange dropped0.9% in July, the Big Board said. The NYSE said debit balances in margin accounts ofcustomers of member firms fell to $244.97 billion in July from $247.2 billion in June.Statistics on margin debt, which is accumulated when buying stocks with funds borrowed from a broker, are closely watched for insight into stock-market trends. For example, a steady rise in margin debt, which reached a high of $278.53 billion in March,preceded the spring market sell-off.
Margin debt: Margin debt is accumulated when investors borrow money fromtheir brokers in order to buy stock. The overall levels of margin debt are monitored closely as a gauge of market trends. Specifically, a high level of margindebt is viewed as a negative for the market because investors are borrowingheavily to finance stock purchases.
Advance/Decline RatioThe A/D ratio shows the number of advancing (gaining in value) stocks versus thenumber of declining issues. A strong (positive) number is a good indicator the rallyunderway is solid. A weak number in an advancing market means the advance islimited in its breadth, and the rally is therefore suspect.
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A declining market with a lopsided A/D line (more negatives than positives)means there is a widespread retracement in prices occurring, and signals overallweakness in the market. However, a relatively even A/D reading in a down marketindicates the bears have control, but by only a narrow margin.The nightly news reports will often report this figure, but it is difficult to get a graphonline (for free, anyway) that shows this over any period of time. To track this on adaily basis, Investor’s Business Daily has it in its “General Market & Sectors” section.
Rampart Time IndexThis indicator (a regular feature in Barron’s), is shown two ways: the CompositeCall Index and the Composite Put Index. Both measure the time premiums on sixmonth near-the-money option contracts for 1,836 stocks. They show at a glance, ona broad scale, the premiums options traders are willing to pay for a call or put.Today is May 1, so the Rampart Time Index will look to November contracts. IfXYZ Company is selling at $50 per share, and the November 50 Calls are offered at$65, the time premium is $15. News one way or the other on XYZ might send thispremium up or down. The more bullish the outlook for XYZ, the bigger this premiumwill be. So by using 1,836 stocks and measuring the time premiums, the RampartTime Index provides an investor with another measuring stick of market sentiment.
Closed-End Fund IndicatorThis indicator tracks the premiums of closed-end funds, a vehicle utilized primarilyby small investors (not institutions). Closed-end funds differ from their open-endcousins because they trade like a stock in the market, complete with bids and offers,and their NAVs (net asset values) may or may not be the same as the market price.This premium or discount of share price to NAV indicates the level of optimism (premium) or pessimism (discount) among retail investors. Note: The little guy, beingless experienced, is wrong more often than the professionals. Therefore, this sentiment indicator would be a contrary one; a premium might be a bearish signal, whilea discount to NAV would show fear among the retail populace, a bullish indicator.For more information on closed-end fund indicators, check out theInternet Closed-End Fund Investor’s web site (www.icefi.com),or write them at The Internet Closed-End Fund Investor,P.O. Box 63042, Colorado Springs, CO 80962-3042.
THE MEDIAThe media is a very easy place to begin testing the waters for market sentiment. Beingas objective as possible (tough to do if you’re already invested!), what are the talking
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heads saying on the various financial broadcasts? Are they upbeat and positive, or arethey speculating as to how bad it is and when it will be over? One thing to note: Whenever you watch a program that has some market guru or analyst featured, that person’scomments about which direction the market will take is stating an opinion. If 10 gurusspoke on one day, most likely you’d hear 10 different opinions. But an investor can getsome perspective as to the overall consensus (are we going up or are we going down?).
CNBCCNBC is regarded as the leader in financial news, and that’s why I usually keep mytelevision tuned to the station. The content is split into two sections: “Real News”and “Opinions.” The “Real News” half is just that: current news headlines for business and nonbusiness news. If a catastrophe has occurred (like an earthquake inCalifornia, for example), I want to know about it ASAP. Plus CNBC offers a tickerthat’s real-time (no 20-minute delays). This is a great way to keep up with stockquotes if you don’t have streaming quotes on your computer.The second half of their programming is opinion. We all have thoughts on wherethe market is going, what stocks will do well, and how to avoid dogs. It’s importantto keep in mind that the analysts featured are touting stocks they’re already in, ortheir firm is promoting at that particular time. Don’t get me wrong; some of this information is good. But just keep in mind that this content is meant to fill airtime.What do you think they’re going to do all day, keep repeating the news on an endless loop like the Weather Channel?Some of the people they have as guests are extremely well-spoken and knowledgeable (check out Mario Gabelli, John Bollinger, and analyst Dan Niles). Othersmay be considered tired warhorses by some traders because they tend to call turnsin the market so far after the fact as to be almost humorous. However, their statedopinions still have major significance since they are highly regarded at major brokerage firms. It’s best to keep your guard up when listening; don’t just run out andbuy their recommendations willy-nilly.Here’s a list of some of the more popular financial news sites:••••
CNBC: www.cnbc.comBloomberg.com: www.bloomberg.com/welcome.htmlCNNfn: cnnfn.cnn.comTheStreet.com: www.thestreet.com
News EventsLike a day ruined or brightened by an unforeseen occurrence, so too can the prevailing sentiment regarding the market as a whole or a particular stock be influenced by a news event. As mentioned earlier, a gross example of pessimism wasprevalent in the fall of 1998 with the financial concerns regarding Brazil and
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Russia. These concerns, when coupled with the danger of a hedge fund’s crisis,made for unusually high degrees of pessimism. Individual companies can buck thetrend of the market as well by announcing some major internal development, or bethe subject of an analyst’s accusation, the validity of which may be doubtful.Traders and investors vote with their money more times than not, selling faster thanbutter melts in a hot car, or buying as fast as they can dial up their brokers.The wisdom of these decisions comes to light only when emotions cool. However, the resulting transitory price swings can and do present beautiful opportunitiesto buy at a discount or sell into an artificially inflated market.Figure 10.7 shows a chart of Tyco International that illustrates the power of themedia in shifting sentiment. In fall 1999 an obscure research house in the Midwestissued a report stating the company had “cooked the books” and its accountingpractices were highly suspect. The SEC followed closely with what it termed a“nonpublic” investigation into Tyco's accounting practices.What ensued in the next few days can best be described as wholesale dumpingby individuals and institutions alike. As you can see, the stock went down sharply.During this sell-off, the company’s senior management went on the record (onCNBC, CNNfn, and every other medium they could find) to deny there were irregularities, confirm business was booming, and stress that the outlook remained bright.
Figure10.7
Tyco Daily Chart (Courtesy of QCharts (www.qcharts.com))
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The analysts who covered the company also affirmed Tyco's innocence, with everyone doing their best to question the source of the story.In the near term, pessimism was high, and the stock sank to yearly lows. However, savvy investors who routinely look for special situations such as this pouncedon the temporary dip and bought like crazy. The entire episode turned out to be atempest in a teacup.History is full of these kinds of disasters. The market looks at them with shortterm horror. But the flip side of the same coin is a tremendous buying and/or tradingopportunity as market participants take advantage of excessive pessimism.
Survey of Newsletter WritersOne of the most widely followed measures of investor sentiment is the survey ofnewsletter writers conducted by the editors of Investors Intelligence (see Figure10.8). Each week, a poll is conducted to determine the levels of bullish and bearishsentiment among newsletter writers. The idea is, while some letter writers are quitesavvy, taken as a whole, they are no better than average investors. As a result, theybecome overly bullish at market tops and bearish at major bottoms. Abe Cohenfounded Investors Intelligence in 1963. Since he passed away in 1983, MichaelBurke has served as editor and publisher. Today, Investors Intelligence monitorsroughly 140 newsletters and conducts polls weekly.There are differences in opinion regarding how to use Investors Intelligencesentiment readings. I look at both the percentage of bulls and bears. When thepercentage of bulls exceeds 60%, it is a sign of excessive bullishness and a majornegative for the market. If at the same time the percentage of bears falls to 20%or less, we are almost certainly at a major market top. If the percentage ofbears rises above 55%, sentiment is excessively negative and the market isprobably approaching a bottom. Investors Intelligence statistics can be foundweekly in Barron’s or through Chartcraft in New Rochelle, New York(www.chartcraft.com).
Investors Intelligence Sentiment Survey
BullsBearsCorrection
LastWeek
TwoWeeksAgo
ThreeWeeksAgo
43.5%33.7%22.8%
47.1%31.7%21.2%
48.6%33.6%17.8%
Figure 10.8 Newsletter Survey (Source: InvestorsIntelligence, 914-632-0422)
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Survey of newsletter writers: Statistics on the percentage of bullish or bearishinvestment newsletter writers used as information about investor sentiment. It isa contrarian indicator. Therefore, high percentages of bullish newsletter writersare considered bearish, while a low percentage is interpreted as bullish.
VOLUMEVeteran traders look to the measurement of volume for verification of a rally or selloff. Unless big money is in the game, the theory suggests, the strength of any moveis suspect. Big money is an affectionate term for the pension fund managers, themutual funds, and to some extent hedge fund activity. If they’re not interested in astock, the volume is light. If a sector is lagging and volume is light, this indicatesthat professional money managers are not too keen on the prospects in the nearterm, at least of that particular group or individual stock.A good example of institutional involvement occurred in March 2000 when thesemiconductor sector began to be the darling du jour of big money (see Figure10.9). Micron (MU) had traded in a range from around 30 to the low 40s (after adjusting for the 2 for 1 stock split on May 2, 2000), languishing while the rest of the
Figure 10.9
Micron Daily Chart (Courtesy of QCharts (www.qcharts.com))
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Nasdaq had flourished. Institutional buyers pushed the stock upward and out of itstrading range, and alerted investors to a sentiment shift, not just in Micron but theentire semiconductor sector.
MORE VOLUME CLUESSometimes volume spikes will tip you off when sentiment in a stock is shifting. Figure 10.10 shows Amazon.com (AMZN), which at the end of April 1998 experienced a major spike in volume although there was no news to speak of. This type ofevent can be spotted in Investor’s Business Daily in a feature named “The ‘Real’Most Active” that highlights stocks with unusual activity. I like this because it oftenis an indicator of shifting sentiment. Although trading on insider information is illegal, there’s usually a group of people (investors, employees, and vendors) who areclose enough to see what’s happening. These observations spread like wildfire untilthe rumor that something big is happening dies down, and the price of the stocksinks in the absence of hard news.Volume precedes price. The increase in volume indicates some group or groupshave taken a position in a seemingly dormant issue, so said issue could then be puton a watch list of your own making. If there is big volume and no price action, the
Figure 10.10
Amazon Price/Volume Chart (Courtesy of QCharts (www.qcharts.com))
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Volume spikes: A sharp increase in trading activity. When important news concerning a company is disseminated, there will sometimes be abnormally largetrading volume in that company’s stock. On a stock chart, the increasing volume will be visible along the bottom of the graph—it will appear as a tall vertical bar. That graphical representation of the abnormally large volume is alsoknown as a volume spike.
stock is garnering the attention of institutional investors, and is a good indicatorsome fundamental shift in sentiment is occurring. The next volume spike with accompanying price action should confirm a definite shift in sentiment. It’s like thesound of thunder signaling a storm.Volume is also one of the tenets of the Dow Theory, in whichthe initial phase of an upward trend is the accumulationof stock by knowledgeable insiders and astute investors.There are several places online to look for unusual volume activity.• Optionetics.com: www.optionetics.com• Street Index.com: www.streetindex.com/volume_alerts.shtml• Daily Stocks.com: www.dailystocks.com/volume_alerts.htm
CAPITULATIONCapitulation is an event that signals the bottom in a bear market. Fear and pessimism reach their nadir (or pinnacle, depending on your point of view). Many analysts believe that unless capitulation occurs then a true bottom has not occurred.Capitulation is important, but a bottom can be put in without it. It is important because it rids the market of the overhang of people who wish to sell, but who arewaiting for a rise in prices before they do so.The existence of potential sellers after large declines is not consistent with a bottom. In a capitulation setting, you don’t have investors buying at the dip becausethey have all thrown in the towel. Pessimism is so rampant even a weeklong rally ismet with skepticism. At a real bottom genuine fear is in place, and a low-yieldingfive-year CD looks better than anything. The average investor, having been beatenup pretty badly, has had all the pain and discomfort he or she can tolerate. In the end,the investor is just trying to salvage what is left of his or her investments. When thelast of the sellers dries up, only then is the coast clear for a sustainable rally.Capitulation at the top is tougher to identify because everyone is so darn happyand feeling rich. Good news dominates the airwaves and stock reports, grand vacations are planned, and new goodies have been secured. The top is a triple-digit gainon big volume (usually) and is probably just another great day to be in the market.
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The difference between a top and a bottom is that market tops are less precisethan bottoms. Whereas the capitulation of bulls is accompanied by heavy selling,the capitulation of the bears may or may not be accompanied by a bout of buying(to cover their short positions). This is why the term capitulation is usually usedonly for bottoms.Figure 10.11 shows the capitulation of 1998. Note that a true bottom wasn’t hit until October, a month after a massive sell-off. The Volatility Index (VIX), when used inconjunction with this low, signaled investors a true bottom was reached. (It hit 60!)Figure 10.11 shows what many investors probably would like to forget: the 1998bear market that began with a July 20 top, and bounced to a painful conclusion,forming a double bottom on September 1 and October 8 before beginning itsimplausible rally.
COMPARISON INDICATORSA number of indicators, web sites, and techniques utilize the power of comparisonto unveil the strengths and weaknesses of various stocks or economic shifts. Let’stake a look at a few of the most popular methods.
Figure 10.11 Bear Market Capitulation—Dow Industrials (1998) (Courtesy ofQCharts (www.qcharts.com))
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Gold PricesGold is a good sentiment indicator because that’s where some investors go to await theEnd of the World As We Know It. Inflation, wars, and financial instability are the mainreasons gold moves up—another way of indicating fear in the minds of investors. Contrarians won’t start buying automatically, but by watching this one you can see nervousinvestors at a glance and judge if anything nasty is on Wall Street’s radar screen.Inflation fears in early May 2000 triggered a big move, as seen in Figure 10.12