By Michael Cintolo, Vice President of Investments, Editor of Cabot Market Letter and Cabot Top Ten Report
From Cabot Wealth Advisory 4/3/08  Sign up for free Cabot Wealth Advisory e-newsletter

One major reason I think the market is tracing out a major bottoming pattern right now is sentiment—specifically, the ridiculously poor sentiment of the last few weeks leads me to believe the market's next big move is up.

Huh? If you're not a student of the market, the above statement seems totally wrong. If everyone's pessimistic, the market will have a hard time moving up, right? Wrong.

Sentiment is used as a contrary indicator—when the vast majority of investors (not just some, but a vast majority) are enthusiastic, it means most of them have already bought shares...and thus, there aren't enough big buyers left to drive prices higher. Conversely, when everyone's talking about recessions, depressions and crash-type scenarios, they've usually already sold their stocks. So there's not enough selling pressure to drive prices lower.

Of course, in the long run, the market is going to follow fundamental factors such as earnings, sales, inflation and interest rates. But in the intermediate-term (one to four months into the future), sentiment has a powerful effect on the market.

That's all well and good, but how do you measure sentiment? Admittedly, it's tough. If you want hard-and-fast numbers, you can use things such as the percent of newsletters that are bullish (it recently hit a ten-year low) and put-call ratios. But we've found that many anecdotal sentiment-related measures are just as useful at spotting turning points...if you know where to look.

The obvious example in the anecdotal camp is the neighbor/cab driver/shoe shiner who brags about all the money he's making in the market. I vividly remember, for instance, a local repairman in our office during early 2000; he stood in front of our board (which lists all our recommended stocks) and was giving us his opinions on them all, as well as suggestions as to what he was buying and selling. Nothing against repairmen, but that's like us talking about our opinion on the latest engineering designs and specification—when novices are bragging, you're usually late in the ballgame.

Interestingly, one of the best ways to get a read on public sentiment is by scanning magazine covers. (Cosmopolitan or GQ doesn't count.) BusinessWeek, Fortune, Time and The Economist are notorious for writing about yesterday's news—i.e., reporting dramatic events that have already taken place. Oftentimes, negative cover stories come right at market turning points.

Recently, we've seen a slew of negative covers. The Economist's cover from March 22 simply said "Wall Street: A ten-page special report on the crisis." There was a huge crack running down the center of the page, depicting an earthquake for investors.

But BusinessWeek has been a multiple offender. Its March 24 issue was titled "Waking Up to the Recession." A month before, the magazine's cover blared "Credit on the Edge." And just this week, there's a huge red picture of Fed Chairman Ben Bernanke that says "Reluctant Revolutionary—Special Report on the Financial Crisis."

One piece of anecdotal evidence is meaningless, but when you see all these fearful covers, it's telling you the public believes the worst is yet to come...which leads me to believe the market is likely forming a bottom around here! There's more to it than that, but these bearish stories are certainly a help in the contrary world that is the stock market.

FYI, in the months ahead, after a bull market has pushed stocks much higher, it wouldn't surprise us to see covers like "Comeback Kid:  How America skirted disaster and is thriving in the post-credit bubble world." That will be a hint to lighten up, as most of the investors who are worried today will have finally come on board...putting the sellers back in control.

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