Investor Sentiment - Lesson 4

In life, in general, and in investing, in particular, we are all part of the herd. Investor sentiment is powerful, as we are all subject, to some degree, to the forces of mass psychology. When investor sentiment changes about a particular stock or about the market as a whole, the herd has the power to push its target sharply in one direction or the other. On the surface, it appears that by keeping in tune with the herd, we can garner huge profits.

This is true, to a point. In fact, we often preach the intelligence of not trying to predict how far a certain market move will go or how long it will last. Instead, we’ve found that it is much more rewarding to simply observe the current trend and stay with it. In short, we’re telling you to stick with the herd.

But while riding the power of the herd is usually the most profitable way to go, there are times when it is the worst thing to do. How can this be? When a vast majority of the subjects of the herd feel the same way about an investment, a turning point is at hand. To understand why, we just have to look at basic supply and demand.

When an investor believes a stock, industry or entire market is heading higher, he naturally commits funds to those stocks. This only makes sense; he’s bullish. There’s nothing dangerous about that. But when most people become bullish, and they commit money to those same stocks, a problem arises. Because most investors have already bought in, the buying power to push the stock higher has disappeared. At this point, when nearly everyone is optimistic, the sellers take control and prices fall.

Conversely, when pessimism is rampant, most investors have already sold out. They believe there is no money to be made on the long side of the market. When this extreme is reached, they buyers can take control, because there are no selling pressures ready to oppose them.

Our point in all this is to help you use contrary opinion in your investment decisions. Benton W. Davis, in his 1964 book, Dow 2000, explained contrary opinion in a unique way.  Here’s some of what he had to say:

“Think of it this way. There is this great big pasture stretching up and down on a long hillside with a fence all around. Today there are eighteen to twenty million sheep in this pasture, the majority quite unseasoned. In fact they would seem to be, at times, conducive to panic. If someone appears shouting “wolf,” these sheep can take off as one, in a cloud of downhill dust and thundering hooves, to wind up a shivering, shaking mass, stopped only by the bottom wire.

“It then took considerable time, considerable coaxing, and factual existence of a great bull market to get these sheep out of their bottom huddle. But, when they finally got started they galloped back uphill almost as fast as they had charged downhill, gathering recruits on the way up, before too long winding up against the top wire, in complete reversal of outlook, a now happy herd of panting optimists.”

What you want to avoid is being the sheep that’s running downhill with all the other sheep just before you reach the bottom wire. And you sure don’t want to be the last panting optimist at the top wire! It all comes down to staying on the right side of shifting investor sentiment until mass perception reaches an extreme level.

While it’s very difficult to pinpoint tops and bottoms based on sentiment, contrary opinion can nonetheless help you become a little more conservative near tops and a tad more aggressive near bottoms. And while these small adjustments in your portfolio may seem insignificant, they become a big help to your portfolio performance because they come near market turning points.

So what should you look for to identify extremes in investor sentiment? There are a number of technical indicators, ranging from the put/call ratio to Investors Intelligence’s survey of the bullishness or bearishness of newsletter writers. Beyond those indicators, newspaper and magazine headlines and general willingness to buy on the part of friends and relatives can give you a hint as to where we are in the market cycle. (Is your grandfather giving you hot stock tips every time you see him?)

By watching for extremes in the level of investor sentiment and adjusting your investments accordingly, your investment results are sure to improve.

Timothy Lutts knows all about investor sentiment and how to make money in spite of it. He is Cabot’s President and Chief Investment Strategist, and Chief Analyst of Cabot Stock of the Month.

Next: Technical Analysis

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