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Investor sentiment can help investors spot turning points in the market. But not in the way you might think.
Investor sentiment is 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), investor sentiment has a powerful effect on the market.
That's all well and good, but how do you measure investor 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 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 and GQ don’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.
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. There's more to it than that, but these bearish stories are certainly a help in the contrary world that is the stock market.
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