 a  great  deal  more  information  investors  can  look  at  fortheir selection techniques. What I have found, however, is so overwhelmingthat we do get bogged down in the details. The three points made in thischapter are just about all you need. Next is some reﬁnement of our tech-niques and where and how to obtain the information.
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Experience is a good teacher, but she sends terriﬁc bills.—Anonymous
The majority of short-term traders lose money. Is there a way to do the op-posite of this? If the majority of traders are wrong the majority of the time,wouldn’t it behoove us to do the opposite of what they do?
This is far from a new idea. Writing in the 1930s, Garﬁeld Drew wasmost  likely  the  ﬁrst  analyst  to  not  only  espouse  this  view  but  present  aworkable solution to the problem. Drew classiﬁed public investor activityinto two categories: (1) customers’ equity or cash balances at their brokersand (2) odd lot short sales.
The  more  enduring  of  these  two  indicators  has  been  odd  lot  shortsales. Since an odd lot, Drew reasoned, was less than 100 shares, such ac-tivity most likely represented the small investor, someone with not enoughmoney to buy in the traditional 100-share increments.
For over 70 years this point has been proven correct; abnormally highlevels of odd lot short sales occur at market lows, while a decline in odd lotshort sales (thus indicating public bullishness) usually heralds market rises.It is a truism, but a sad one, that the majority of investors just can’t seem toget it right.
But we can fade the majority because the majority of people are not
rich.
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Other  analysts  such  as  Wally  Heiby,  Richard  Dysart,  Marty  Zweig,and Ned Davis have done additional work along this line. Their work hasbeen  regarding  overall  stock  market  timing.  Perhaps  most  notable  hasbeen  the  Investors  Intelligence  service,  which  measures  the  sentiment  offolks who write newsletters. For over 35 years the record of the hotshotnewsletter writers has paralleled the public’s inability to correctly forecastfuture activity.
Jim Sibbett, a commodity analyst and the original publisher of MarketVane, began recording the bullishness of newsletter writers on individualcommodities in the late 1960s. His work showed that not only could senti-ment data be used for overall market timing, but it also could be used forindividual commodity timing.
His data is quite clear: All of the major commodity markets respond totoo much adviser bullishness by declining, too little bullishness by rallying.Sibbett’s  work  was  all  done  with  weekly  data.  This  changed  whenJake Bernstein began measuring 50 traders’ bullishness/bearishness on adaily basis.
His work on daily sentiment, on a list of widely followed commodities,drives home the same point; even on an individual and daily basis, investorsentiment can provide real insight into the next move in the marketplace.
HOW INVESTOR SENTIMENT IMPACTS INDIVIDUAL STOCKS
To further this concept I began measuring investor sentiment toward indi-vidual  stocks,  namely  the  30  stocks  in  the  Dow  Jones  Industrial  Averageplus a few of the most popular issues such as Qualcomm, Sun Microsys-tems, and Apple Computer.
Thanks to the Internet, it is now possible to track many, many adviserson a daily as well as weekly basis to cull out the majority opinion. Hereto-fore,  this  would  have  been  almost  impossible  to  do  in  a  timely  fashion.Now, with instant communication all over the world, it is possible to col-lect the views of the majority.
While  the  speciﬁc  construction  index  I  am  about  to  show  is  propri-etary,  the  general  components  are  not.  You  could  do  this  yourself  if  youhad  the  resources  and  time.  The  index  is  arrived  at  by  visiting  web  sitesand print media to determine how many of the surveyed analysts are bull-ish. This value is then taken as a percent of all votes cast, thus giving a baseor raw number of percent bullishness.
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There is some smoothing of the data, but only after a technical mea-sure of public bullishness has been tossed into the concoction. Instead ofinterviewing individual members of the trading public each day, we mea-sure their mostly likely activity in the market as a percent of all market ac-tivity. This is a slightly different view of what I ﬁrst began writing about inthe  1960s  in  my  work  on  accumulation  and  distribution.  Put/call  ratiosalso provide an important factor in the index.
These measures of daily activity are blended into the weekly readings.What I discovered was as illuminating as it was conﬁrmatory of whatone would expect: Intermediate-term market highs are marked by high lev-els of investor optimism, while market lows are almost always accompa-nied by low levels of optimism.
René  Descartes,  the  seventeenth-century  French  philosopher  creditedwith the line, “I think, therefore I am,” is perhaps the founding father ofthis  philosophy  as  well.  He  apparently  made  his  living  gambling  and,  inaddition to his pontiﬁcations on life, left us with this thought for specula-tors: “It is more likely the truth will have been discovered by the few ratherthan by the many.”
In  trader  talk  that  means,  “Just  when  the  many  have  discovered  the
trend is up it is most likely to change.”
So,  whether  it’s  Descartes’  thought  or  Garﬁeld  Drew’s  work,  MartyZweig’s, or mine, a truth of market activity has been uncovered or at leastconﬁrmed: You can fade the uninformed investor or majority view most ofthe time.
LET THE EVIDENCE SPEAK FOR ITSELF
Figures  9.1,  9.2,  and  9.3  depict  sentiment  on  weekly  charts.  As  you  cansee, I have marked off the excessive bullish levels with a reading over 75percent, while market lows are most likely to take place with 25 percent orless of our survey sample looking to be buyers.
Our Basic Rule
The  ﬁrst  rule,  if  you  will,  is  that  these  zones  of  excessive  bullishness and bearishness are where prices usually reverse themselves. It is as Her-aclitus  said  in  500  B.C.:  “Every  trend  must  go  too  far  and  evoke  its own reversal.”
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As proof of this phenomenon, let’s look at Figure 9.1 of J. P. Morganfrom  1996  through  the  spring  of  2000.  I  have  marked  off  the  excessivebullish  and  bearish  areas.  The  vast  majority  lead  to  setting  up  proﬁtabletrades. This is, indeed, the rule rather than the exception.
Figure  9.2,  of  3M,  shows  the  same  general  observation  to  be  true.
Figure 9.1 J.P. Morgan 1996–2000
Figure 9.2 3M 1996–2000
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Figure 9.3 Merck 1996–2000
When  the  majority  of  advisers  are  too  bullish,  more  than  75  percent  ofthem, prices are more likely to decline than rally over the ensuing weeks.
By  the  same  token,  when  the  number  of  bullish  advisers  is  less than 25 percent the odds of a market rally are greatly enhanced. Indeed,the  most  proﬁtable  rallies  in  these  four  years  were  all  given  birth  by sentiment readings in the lower quartile, as I have marked off. The sec-ond law of thermodynamics in physics teaches that all things tend to gofrom  an  ordered  state  to  a  less  ordered  state.  Disorder,  or  entropy,  al-ways increases.
That’s pretty much what happens here. All that order of the trend, adecrease in the entropy of the common outlook, actually increases the en-tropy in another area, namely trend reversal.
Let’s  turn  our  attention  to  a  disparate  company,  Merck  (see  Figure9.3).  It  matters  not  what  the  company  does—it  can  be  banking  like  J.  P.Morgan,  a  diversiﬁed  technology  company  like  3M,  or  a  drug  stock  likeMerck.  The  rule  of  the  jungle  still  prevails.  Virtually  all  of  the  ideal  buyand  sell  times  in  this  stock  from  1997  forward  have  coincided  with  oursentiment index being in the correct zone.
The  problem  is,  there  may  be  readings  that  do  not  produce  majormoves. The index did call just about all major highs and lows—that’s thegood news—but it gives a few signals that are not accurate. I will show onetechnique to avoid some of these, and you may have some techniques ofyour own.
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HOW OPTION TRADERS CAN USE THE INDEX
Perhaps you are a long-term player in Merck. You own the stock but wantto earn some extra income by writing puts and calls. The sentiment indexcan be of great value. Simply write puts when less than 25 percent of theadvisers are bullish, and sell calls against your position when over 75 per-cent are bullish.
Perhaps you are following a stock you want to add to your portfolio.The only question in your mind is when will be the best time to buy. Thesentiment index can come to your rescue! Why make your purchase of thestock  when  the  majority  has  been  buying,  given  the  majority’s  record  ofmost often doing the wrong thing? Simply wait until the weekly index dipsinto the 25 percent area or lower and then make your investment.
I have marked off some of the 25 perent zone buy points for your ob-servation. Considering the mechanical simplicity of the technique, the re-sults are truly remarkable.
Figure  9.4  shows  buy  arrows  for  this  stock  from  1993  into  2000.While not perfect (nothing in the real world of speculation is), it is awe-some to see how many of the arrows denoted ideal entry points for thelong-term  acquisition  of  Merck,  or,  if  you  owned  the  stock,  precisepoints to write puts so you would get the income without the stock be-ing taken away.
No longer do you need to throw darts; instead, track the dart throwers!
Figure 9.4 Merck 1993–1997
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America’s love affair with Microsoft came to an end in the year 2000,largely due to government action. Countless families lost millions of dol-lars thanks to the judicial and bureaucratic attitude of “I’m from the gov-ernment and am here to help you. The most successful entrepreneur in thecountry’s history must have cheated; how else could he have succeeded?”
Interestingly enough, however, our fade-the-crowd rule was alive andworking.  The  sentiment  index  stood  at  77  percent  the  week  prior  to  thelargest  decline  in  the  company’s  history  (see  Figure  9.5).  Indeed,  most  ofthe  major  moves  have  been  clearly  indicated  by  the  excessive  bullishnessand bearishness of our favorite group of advisers.
This is not a new phenomenon. In Figure 9.6, which shows Microsoftfrom 1992 to 1995, the same pattern of excess was at work. What we arereally seeing here is the natural cycle of a pendulum swinging from every-one believing the trend is one way to no one believing.
Speculation is largely the art of doing what others are not, when they
think they are doing what they ought to be doing.
WHAT MAKES THE ADVISERS TOO BULLISH AND TOO BEARISH?
The  evidence  is  pretty  convincing,  as  you  have  seen.  But  why  is  this  so?What is the function behind the index?
The driving force of the index is what the market has been doing. The
Figure 9.5 Microsoft 1997–2000
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Figure 9.6 Microsoft 1992–1995
stronger and longer a rally is, the more bullish these folks become. Onlyone thing makes these folks bullish, it appears: a strong market rally. Onlyone  thing  makes  them  turn  bearish:  a  decline.  There  is  a  dichotomy  atwork  here.  True,  the  trend  is  your  friend.  But  it  is  exactly  that  trendstrength that gets these advisers to a bullish or bearish extreme.Yet isn’t the ﬁrst rule of trading not to buck the trend?I  think  the  sentiment  index  helps  us  understand  the  old  adage,  “The
trend is your friend . . . until the end.”
The  end  of  a  trend,  a  moneymaking  opportunity,  comes  when  toomany of these players have climbed aboard the bandwagon. In short, thesentiment data has as good a record of telling us when we are close tothe end of the trend as anything I have seen in my 40 years of trackingstock prices.
Trend strength—that is, a strong rally—apparently has a hypnotic ef-fect on market prognosticators. The greater the rally, the deeper their som-nambulistic trance. Nothing gets these people more bullish than a rally. Itis  almost  as  though  they  stop  thinking,  and  in  lemminglike  fashion,  thecloser to the end of a trend we are the greater the number wanting to jumpoff the cliff!
Should you take the time to study the index, you will see that near theend of the trend this camp is on the wrong side of the trade. They begingetting in phase with the trend around the midpoint, then become exces-sive in their view as the trend nears completion. In other words, the crowd
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can catch a trend and be correct, for a while. The stronger the trend themore committed to it these folks become.
Keep in mind that this group can and will be correct in their marketoutlook  at  the  midpoint.  It  is  when  the  crowd  becomes  extraordinarilyone-sided,  with  readings  above  75  percent  as  potential  sells  or  below  25percent as potential buys, that we are alerted to opportunity.
Our entire upbringing has been that the majority is right; they get torule, they prevail. But the majority (or mob) rule can be a dangerous posi-tion. If there are three of us and two of us decide to kill you, should wehave that right? The more I have seen the fallibility of the crowd the more Iquestion how great the leaders we have voted into ofﬁce really are! Sincechildhood we have been taught the majority is right. We decide the futurebased on a popular vote. If we are not certain, we take a survey!
The majority view is not always wrong; it is not a given it will be in-correct. But the evidence shows, and rather markedly so, the crowd is morelikely to be wrong than right at the extremes. Thus we are given an advan-tage, a window of opportunity, when our odds for success are increased.What more could a speculator want?
Even then we should recognize that we might still be early, so we mostlikely need additional conﬁrmation or a short-term entry technique to en-ter  the  trade.  There  are  myriads  of  entry  techniques,  but  without  theproper setup, such as what the sentiment index provides, most are doomedto fail.
ADDITIONAL INSIGHT INTO THE INDEX
By  now,  I  trust,  you  get  the  point—we  have  an  index  here  of  real  value.And I suspect you have asked, is there any way we can ﬁlter out some ofthe less desirable calls it makes?
Certainly,  there  is,  but  don’t  expect  to  sidestep  all  the  mineﬁelds,  as
that’s never going to happen.
As a long-term buyer of a stock, I have noticed that the very best 25percent buy signals come when the overall market trend is up. We can mea-sure this in a most elementary way by simply saying that if the weekly clos-ing price is above the 18-week moving average the longer-term trend is up.If at this same time a sentiment index buy zone is reached it will be abetter bet to buy than if the price is below the 18-week average of clos-ing prices.
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Let’s begin the analysis with a weekly chart of Disney from 1997 into2000 (see Figures 9.7 and 9.8). Here I have taken the liberty of markingwith arrows the instances when both conditions were met—the long-termtrend was positive (i.e., the weekly close of above the 18-week average washigher), while the sentiment index was below 25 percent. I have X’d out allthe other signals. Notice how many of them there were! Some were good,some  not  so  good;  but  all  the  signals  when  the  two  tools  were  in  synch
Figure 9.7 Disney 1997–1999
Figure 9.8 Disney 1998–2000
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worked out. There were only three from 1997 into 2000. I like that; thefewer trades the better.
Keeping the preceding discussion in mind, let’s revisit Merck in Figure9.9,  which  shows  only  the  buying  indications  when  the  two  indicatorswere congruent. What a difference from Figure 9.3—far fewer trades, withvirtually  all  of  them  making  money  if  you  exited  the  ﬁrst  time  the  indexwent above 75 percent.
DON’T INHALE
Figure 9.10, that of Philip Morris, presents plenty of opportunities to buyusing  the  sentiment  index.  Many  of  them  made  money,  until  1999  whenclass-action lawsuits brought prices tumbling. Note how none of the buypoints would have been acted upon, because the weekly close was belowthe 18-week average.
There are certainly other approaches an investor might choose in order
to ﬁlter out the less than ideal points, but this one is not bad.
Short selling would be instigated with just the opposite rules: the senti-ment index above 75 percent while weekly closing prices are below the 18-bar average.
Finally, I am leaving you with seven charts to study of different stocks
Figure 9.9 Merck 1996–2000
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Figure 9.10 Philip Morris 1994–1997
and different time periods so you might get a better feel for the index andperhaps  even  develop  your  own  way  of  using  this  valuable  data.  What  Ilike best about this notion is that it is not paralogistic; it is the way marketshave always worked since the early measurements of Garﬁeld Drew.
WHY STOCKS DO WHAT THEY DO
In  the  long  run  stocks  move  up  and  down  for  real  reasons—things  likeearnings,  debt,  insider  buying,  and  the  like.  They  really  matter,  as  anylong-term viewer of stock market history realizes. In fact, I believe thesefundamentals to be among the best ways of isolating long-term positionplays in equities.
However,  on  a  shorter-  or  intermediate-term  basis,  prices  ﬂuctuate,and sometimes quite wildly. Many of these gyrations are undoubtedly ran-dom and defy prediction. Yet, the vast majority of these intermediate-termhighs can be found to shape up at the precise moment my sentiment indexis telling us there are too many buyers.
Market  lows  are  just  the  reverse.  The  majority  of  them  are  formedwhen there are too many people thinking or advising others to sell, clearevidence  that  the  market  seems  destined  to  prove  the  majority  of  peoplewrong the majority of the time.
An equally interesting point is that it does not seem to matter what the
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company  does,  or  in  the  current  market  environment,  doesn’t  do.  Whatclearly does matter is that when too many of the crew get on one side ofthe  stock  market  boat  it’s  going  to  tip  back  the  other  way  (unlike  a  realboat),  just  as  when  the  majority  think  they  have  it  ﬁgured  out  that  thetrend is up, its predestination is to change.
It will pay big dividends to study the fundamental underpinnings of acompany to select long-term investments. But when it comes to timing theentry  into  these  issues  I  certainly  want  to  be  doing  what  the  majority  ofothers are not doing.
Thanks to today’s communications and Internet sites, it is possible totrack and tabulate the mind-sets of many of the players in this game so thatwe,  hopefully,  do  not  get  caught  up  in  the  peer  pressures  that  make  formarket turning points.
NOTES FROM MY TRADING WITH THE INDEX
I  have  used  this  index  in  a  variety  of  ways.  The  most  interesting  one  isthat  I  have  written  calls  when  the  majority  of  the  advisers  are  bullish.(One collects a premium from the buyer of the call, hence an immediatecredit is given your account for the option price. You cannot make morethan the premium paid to you, but you are certain of that proﬁt. If, how-ever, you are wrong, when you cover the position you can deduct fromyour loss the proﬁt from the premium the call buyer paid you.) I’ve notdone this often, but (knock on wood) so far I’ve never had a losing trade.My strategy has been to ﬁnd a commodity (because that is what I primar-ily trade in), but the same idea has application and merit for stocks thatare in substantial downtrends.
I do not want a trend to have been down for more than seven months,simply because we know that all trends, at some point, must end. There isa much higher probability for a seven- or eight-month trend to be reversedthan one that has been in effect for just a couple of months.
Given that setup, a strong downtrend market, I then wait for the in-vestor sentiment index to get above 80 percent. The week it does this, justbefore the close of Friday’s business I write calls on the future contracts.Just to refresh your memory, writing a call gives someone the opportunityto buy the commodity (or it could be a stock) from me in the future. Thebet the buyer of the call is making is that prices will go substantially higher,enough  to  pay  off  the  premium  I’m  charging  as  well  as  to  overcome  the
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strike price (the price the call is written for). If I write a call on a stock at$36 a share to expire in 90 days, the call will be worthless if the price ofthe stock is equal to or less than $36 at expiration.
Since the advisers have been very bullish on the stock, or commodity,the option premium tends to be higher at these turning points due to theexcessive optimism that prices will go higher. My objective in the trade hasbeen a proﬁt of 50 percent, so if the option that I’ve sold declines by morethan 50 percent in value I nail down my proﬁt. I do this procedure on Fri-days because the poor patsy buying the option from me already faces twodays  of  decaying  premium.  If  the  option  were  to  go  against  me—that  is,prices rally so much the option increases in premium to the point of beingequal to the premium I was paid for the option—I would exit and scratchthe trade.
The entire strategy is to ﬁnd a nice downtrend market, wait until toomany people get too bullish, then write call options. I’ve also done the re-verse (write puts in an uptrend) with equal success.
Here I look for a market that is in a strong uptrend—but again, notone  that’s  been  in  effect  for  more  than  seven  months.  I  then  write  putswhen the advisers get excessively bearish. My belief is that since the trendis up it will most likely continue and the advisers will again be incorrect.The nice thing about this type of option writing program is since the ma-jority of advisers (and thus the public as well) are naive and pessimistic onthe stock or futures contract and believe prices will go lower in the future,this makes them willing to pay more for a put option at this time as op-posed to when the market has been rallying. This gives me the best of bothworlds, a market set up to rally at a time people will pay even more thannormal for a put option due to their emotional bearishness.
There are some stellar examples of how important this index can be inan investor’s arsenal of timing tools, as you have seen. In addition to theprior  examples,  I’m  showing  a  few  more  charts  of  individual  stocks  foryour  own  study,  notably  Wal-Mart,  Intel,  and  IBM.  (See  Figures  9.11through 9.17.)
SEASONALITY AND STOCK PRICES
Commodity traders bring a unique perspective to the ﬁnancial markets, aswe have known for years that there are seasonal inﬂuences to commodity
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Figure 9.11 INTC
Figure 9.12 IBM
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Figure 9.13 Qualcomm
Figure 9.14 Sears
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Figure 9.15 International Paper
Figure 9.16 Wal-Mart
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Figure 9.17 Microsoft
prices. As an example I would refer you to my book, Sure Thing Commod-ity Trading: How Seasonal Factors Inﬂuence Commodity Prices, written in1973. The point of the book was that there are somewhat reliable seasonaltimes for commodities to rally or decline.
This may be more apparent in commodity prices due to weather andto  harvest  and  planting  time  periods.  Additionally,  one  can  look  at  theconsumption  side  of 