10. The Fourth Factor: Psychology—Greed Versus Fear
Sometimes what happens in the market just doesn’t seem to make any sense at all.
We get up in the morning to find the sun is shining. Our vacation is scheduled to start on the weekend, and we feel pretty cheerful. Not only is our own life looking good, but there seems no reason for the stock market to burst our bubble. After all, fundamental valuations are reasonable, interest rates are relatively low, all the recent indicators of economic activity signal that growth is alive and well, and momentum metrics are sending positive signals.
And then it happens. As we watch, the market indexes dip a little, just a fraction of a percentage point. But with each hour that passes, the dip becomes larger. By midday, it’s significant. The CNBC anchors are all abuzz, and major indexes have fallen a full percentage point. What’s afoot? We call our brokers and investment advisors, only to find that they are just as baffled as we are. Should we worry? It’s impossible not to—but why? As we fret, the relentless declines get worse. By the time the closing bell rings on the floor of the New York Stock Exchange, the major indexes have given up more than 2% of their value, all without any obvious cause! There’s no giant corporate bankruptcy to point to, no piece of nasty and disappointing economic data to blame. Hmm, maybe it’s time for us to jump on the bandwagon and begin to sell our own stocks?
What has just happened is that emotion has sent the stock market on an extreme rollercoaster ride and tested your nerve. You shouldn’t worry about such short-term phenomena, but any time that a selloff drives the market below certain critical levels or whenever the rest of the investment world seems to be fighting to get out the same exit, it’s hard to resist all that anxiety. None of our other metrics may be sending out warning signals, but everyone else is panicking as if the world is about to come to an end—and sometimes that is all that is needed to affect significantly the way a market moves.
That’s the way irrationality creeps into the financial markets, and it happens more often than you might imagine (in both directions). What was rational about the trading day in mid-October 2008, when the Dow Jones Industrial Average swung more than 1,000 points in a single trading session—a record intra-day move at the time—only to close with a net change of less than 200 points? For all the scholarly research insisting that financial markets are rational places and that all known information is reflected in stock prices, when you’re in the midst of an emotion-driven selloff or rally it’s hard to keep your emotions isolated from your decision-making process. Investing remains an emotional process. I know, intellectually, that I need to buy when prices are low and sell when they are high, but it is unbelievably hard to do this. Time after time, I have found myself entranced by the Siren call of a bubble in the making, as I did in the mid-1980s during my brief flirtation with the idea of becoming a real estate investor, as I described in Chapter 8, “The Second Factor: The Economy—Headwind or Tailwind for Stocks?”
Being a contrarian, whether it means shunning bubble mania or embracing downturns, is never easy. When you have just watched the stock market wipe 5% off your total net worth in a single trading session, have lost 30% in the last few months investors found themselves in the dog days of autumn 2008, the idea that this might just be a great long-term buying opportunity sounds an awful lot like throwing good money after bad. All your instincts are screaming at you to take shelter from the stock market storm and protect yourself from further damage. Unexpected market declines like the one I described at the beginning of this chapter hurt not just your net worth, however, but also your confidence. And as I discussed in the introductory chapters of this book, most individual investors don’t have a process governing their investment decisions and instead rely on what their gut is telling them about deciding when to buy or sell. Alas, the gut isn’t a very reliable market indicator. It screams at you to pull back after you lose money and buy more as valuations soar. So, how can you make emotions a manageable part of your investment process? That is the focus of our fourth factor: market psychology, sentiment, and emotion. Collectively, the metrics I introduce you to here will help you filter others’ emotions out of your investment decision-making process. And there is a bonus: Thinking about emotions in this analytical manner will help you remove your own emotions from the mix.
Although it took me another decade to begin thinking systematically about market psychology as a factor in its own right, I learned the hard way never to discount the impact of emotions on financial markets in October 1987. To those of us who experienced it firsthand, that was not only unforgettable but nearly unendurable. To this day, it remains the single most debilitating and helpless professional experience of my career, including the much more recent selloff of the autumn of 2008. (Back in 1987, an almost eerie mood of despair and confusion gripped all investors; this time around, curiously, many individual investors seemed to keep their heads. In 2008, the panicky selling came primarily from institutional investors, such as leveraged hedge funds, and although it was painful, it was spread over several weeks.) I’m sure that trading screens boasted more flashing red lights than the worst neighborhoods of Amsterdam and Bangkok combined. All any of us could do was to watch, in agony, as the stock market melted down in front of our eyes. With hindsight, I believe the loss of control hurt as much as the profit plunge. I felt as if I should somehow know how to survive a bear market. But I didn’t have a clue. When the market finally closed on Black Monday, I left the office. On the street, I saw pedestrians crowded three deep looking at the electronic ticker displayed in brokerage office storefronts, trying to calculate the magnitude of the damage to their finances. Normally a hive of activity, the street outside my office that October day felt downright funereal. All of us felt we were witnesses to some kind of epochal event, along the lines of Pearl Harbor.
Astonishingly, those investors who responded to their instincts and fled for shelter in the coming days missed one of the biggest buying opportunities in stock market history. True, the S&P 500 Index didn’t rebound immediately from its 22% loss in October, and in mid-December it was still lingering 5% below the closing price on Black Monday. But by the following February 1988, it was trading 10% higher above its November lows, and by the end of 1988 had soared 20% since Black Monday’s close. A year later, at the end of 1989, the market had posted a 59% gain since the crash and was 15% ahead of its pre-crash levels. True, you would have had to be an automaton to be able to disregard the market’s panic. But however emotional an investor may be, being able to rely on a process that addresses the risk and opportunities that emotion creates in the financial markets during times of turbulence is an investor with an edge. Only a process can help investors conclude whether a big market move is due to hysteria or some kind of shift in other factors. Only after you have drawn that conclusion can you decide how to assess the risks and rewards that appear and respond rationally.
Market psychology, like personal liquidity, is what I refer to as “landscape” factors. Although momentum or fundamentals can provide direct market signals that I can rely on when doing my primary analysis, these landscape factors tell me what is going on in the background that I can’t afford to overlook. Just as politicians use opinion polls as a way to gauge the nation’s mood and figure out what they can (or should) undertake with respect to their policies, investors need to pay attention to psychology. Indeed, if you look around you’ll find lots of financial market equivalents of those surveys that you can incorporate into your decision-making process.
It wasn’t until the aftermath of the dot.com bubble that I realized I needed to incorporate investor psychology into my own investment process in a formal way. I needed indicators that would signal when other such periods of irrational exuberance, to borrow the famous phrase used by former Federal Reserve Chairman Alan Greenspan, were taking shape. In January 2007, a metric that can serve as both a signal of liquidity and emotion appeared when the PIMCO Corporate Opportunity Fund, a closed-end fund that boasted a great deal of leverage, traded at a 15% premium to its net asset value. That told me that prospective investors were so eager to grab shares that they were willing to pay extra just to get into this fund. Was the risk really worth it? It was certainly a psychological red flag—investors were clearly casting caution to the winds. And sure enough, by October 2008, the fund was trading at a 15% discount.
If you’re not convinced that you need to pay attention to emotion as a factor in its own right, just look at how the market reacted to Greenspan’s use of that phrase. Sure, it unsettled investors for a day or two in late 1996. After that, investors tossed caution to the winds and sent valuations soaring for the next three years as they buzzed about a “new paradigm.” Anyone who had been willing to examine the metrics that underpinned Greenspan’s reasoning, however, would have known to heed market psychology closely over that subsequent period. Someone who responded to the underlying analysis over the long term rather than to the use of a particular phrase in the short term would have been prepared to detect the beginnings of the bear market early in 2000.
Just how much can emotional mood swings affect what happens to the market? Take a look at the annual returns posted by the stock market over the course of a year and compare that figure to the range in returns over the course of that year. During the 3-year period from 2000 to 2002, the 30 stocks in the Dow Jones Industrial Average lost ground steadily: 1.4% in 2000, 8% in 2001, and culminated in a 15.9% drop in 2002. That was bad enough. But the pattern wasn’t straight down, slowly and steadily. Instead, the market went on one of those nasty emotional rollercoaster rides. Over the course of 2000, the Dow Jones Industrial Average traded within an astonishingly wide 1,927-point range. In 2001, the intrayear trading range was an even wider 3,107 points, and it grew again to reach 3,349 points in 2002. So, to get to those losses—bad enough in their own right—stock market investors had to survive some nasty bouts of volatility. Anyone who tried to jump in or out at the wrong time could have ended up with a much worse investment performance.
It’s never easy being a contrarian, especially when it requires you to step into the midst of a rout and start to buy. (In the lingo of stock market traders, that’s called being prepared to “catch a falling knife.”) Make no mistake, that’s what I’m asking you to consider, because sometimes you need not just to step away from the crowd but run as far as you can in the opposite direction. Sure, a lot of the time, we’d all rather be wrong in company than right in isolation. Just take a look at some of the research that Jason Zweig cites in his book Your Money and Your Brain. In one study, neuroscientist Gregory Berns and his team asked test subjects to tell them whether two three-dimensional objects were the same as each other or different. When they were asked to make this decision as individuals, 84% of the test subjects got it correct. But when they were offered printouts from four different computers suggesting the wrong answer, their rate of accuracy dropped to only 68%. Placed in the company of four “peers,” other individuals making the same erroneous recommendation, only 59% persisted in making the right decision. The inescapable conclusion is that the more you have to stand up for your views and confront others who insist on the opposite point of view, the harder it is to keep challenging the consensus. (Henry Fonda in Twelve Angry Men aside, the same phenomenon has been reported in jury rooms.) Zweig takes the analysis to an even higher level. Social isolation, he postulates, “activates some of the same areas of the brain that are triggered by physical pain. In short, you go along with the herd not because you consciously choose to do so, but because it hurts not to.” Yes, that’s right. I’m going to ask you to do exactly what Zweig’s test subjects couldn’t: to defy the herd. It may mean that you have to put up with some short-term pain (including ignoring all the persuasion brought to bear by your buddies at the gym or at cocktail parties). But that can boost the odds that you will outperform the market over the long haul. At the very least, by being able to monitor the market’s emotional swings, you should be able to avoid being caught by either extremes of greed or fear.
Of course, as is the case in using each of these five factors, you will need to deploy the right metrics. The problem? Emotion is hard to quantify, and the kind of data you’ll need to use isn’t easily placed on a spreadsheet and subjected to quantitative analysis. For instance, one of those hard-to-measure metrics involves what topics or personalities national news magazines choose to feature on their cover pages. It has become somewhat commonplace to those in a given business or industry that when the latest development in their universe has appeared on the cover of Time or Newsweek, it signals that it is stale news or the investment opportunity has already been overexploited. The truth is that publications such as these are victims of the “trickle-up” news phenomenon. They are trying to capture the biggest pieces of news nationwide. By the time a news item catches their attention, it has gone from being a regional or specialist phenomenon to something about which a wider audience is already aware. Take the July 29, 2002 cover of BusinessWeek, which sported the headline The Angry Market above a photograph of an alarmingly ferocious-looking bear. Dramatic, to be sure. But an investor who responded by shunning stocks would have forfeited the opportunity to profit from a 12% rally in the S&P 500 over the next 12 months.
Even the most prestigious publications are vulnerable to the same phenomenon. Consider the Economist, for instance. By the time it published a cover story on sovereign wealth funds in early 2008, these vast pools of capital from countries such as China, Saudi Arabia, and the Gulf principalities had been snapping up stakes in distressed U.S. investment banking firms for the better part of 2 months, and some were of the verge of pulling in their horns. In the midst of the telecommunications market slump in 2002, the Economist featured the news in a cover story only after most of the selloff had already happened, discussing its causes in its July 18, 2002 lead story, titled “The Great Telecom Crash.” It turned out that the publication date of this story coincided eerily with the sector’s cyclical low (to within days). How much stronger a contrarian indicator could you ask for? An investor who had purchased the telecom sector on the day the issue hit newsstands would have captured a return of nearly 9.5% by the end of the year. One of my favorite examples is the Time magazine cover of November 2, 1987. The title? “The Crash: After a wild week on Wall Street, the world is different.” Well, yes and no. What the magazine intended to portray was the extent to which a heightened degree of risk aversion among investors would alter the long-term investment environment. All that had really changed, however, were valuations: The market had suddenly become considerably cheaper. So anyone who chose not to worry too much about the risk aversion that Time magazine discussed and who responded in a rational manner to this kind of market psychology by investing in stocks at their new lows would have made 65% over the next 5 years. This phenomenon—let’s call it “the curse of the magazine cover”—isn’t confined to the stock market. Back on June 15, 1987, Time sported a picture of the newly appointed Fed Chairman Alan Greenspan on its cover under the headline “The New Mr. Dollar.” Early in his tenure, Mr. Greenspan commented that he thought the U.S. dollar, which had been slipping, was about to hit bottom and start to recover. Whoops! Within 12 months of the issue’s publication, the greenback had plunged another 12.8% against a basket of foreign currencies (on a trade-weighted basis).
Headlines and the stories that run underneath them reflect investor sentiment. For unwary investors, market sentiment can be dangerous. For those able to develop metrics that capture investor psychology, however, studying emotional indicators like this can help navigate the market’s most bullish or bearish time frame. That’s because those indicators are useful in indicating the level of risk associated with a particular asset class or market at any given point in time. One cautionary note: Investor psychology metrics alone aren’t an adequate basis for undertaking an asset-allocation shift or investment decision any more than metrics linked to the other “landscape” factor, liquidity. Instead, you should rely on other factors (momentum, the economy, or fundamentals) for those buy or sell signals, and then turn to market psychology in search of confirmation. If the economic environment is bearish and fundamentals seem the same, but psychology metrics are bullish, that’s not enough to turn bullish. It does mean that you need to take a hard look at those other metrics and reevaluate them in the light of the bullish sentiment reading.
Many investor psychology measurement tools are readily available to individual investors. In each week’s issue of Barron’s, there is a sentiment indicator devised and overseen by the American Association of Individual Investors. (This Chicago-based nonprofit was established in 1978 to educate and help individual investors managing their own portfolios.) Every week, the group polls its 100,000 members, asking them what they expect from the stock market over the next 6 months. Member responses are categorized as bullish, bearish, or neutral and expressed as a percentage of all responses. (A relatively bearish sentiment indicator would be a response of 31%, for instance, while a 46% reading would signal relative bullishness.) Shortly after Bloomberg first made the survey results available on their terminals in 1987, I began trying to develop a trading strategy based on it. My team and I established a series of trading ranges, from “relative bullishness” to “relative bearishness,” using the levels of optimism and pessimism in the index as contrarian indicators. When bullish sentiment dipped below 31%, our strategy would send us a buy signal. We’d continue to remain upbeat about the stock market as long as the level of bullish sentiment remained below 46%. As soon as it broke above that point, however, we were officially in the realm of excessive bullishness, suggesting that it was time to sell. I confess that this approach to investing didn’t make me fabulously wealthy. I would have been better off just buying and owning a broad market index over the long haul. Testing this market psychology–based trading strategy over the 20-year period between 1987 and 2007, I found that an initial investment of $1,000 put to work during periods of bearishness and withdrawn when the bulls ran amok produced $5,025, or an annualized return of 8.2%. Just buying and holding the 30 stocks in the Dow Jones Industrial Average would have given me an 8.4% annualized return, or about $5,186 for every $1,000 invested, over the same time period (see Figure 10.1). (Although, of course, it’s pretty hard for most investors to buy and hold a stock portfolio without succumbing to the temptation to tweak those positions for two decades!)
Figure 10.1 Growth of $1,000 invested in the Dow Jones Industrial Average.
But beyond the fact that this strategy produced more than adequate investment returns, our contrarian approach resulted in a less-volatile and thus less-risky portfolio. Over the 20-year study period, the Dow posted an annualized standard deviation of 15.7%—the “normal” level of stock market volatility. Moving in and out of the market in response to bullish or bearish signals, however, produced nearly the same returns, with an annual standard deviation of only 11.8% (a better risk-adjusted performance). So someone defying the crowd and adopting a contrarian investment strategy would have earned nearly as much over a long period of time (and would have been able to sleep better at night).
There are a number of different ways to gauge how skittish, or how exuberant, investors feel about a financial market, especially when it comes to the stock market. Take the Chicago Board Option Exchange’s VIX Index, for instance. The index, often referred to during the market turmoil of the fall of 2008 during CNBC talkfests, is simply a way to measure the volatility of stocks in the S&P 500. Specifically, it measures the perception of investors in options on the index with respect to the index’s volatility over the coming 30 days. (An investor will buy or sell different kinds of options at different prices if he is expecting a very volatile market than he will buy if he predicts a quiet few weeks.) The VIX is calculated by backing out the volatility assumptions in the prices of all actively traded index options. The CBOE has been tracking volatility data since 1990, because that information is vital to any investor trying to calculate the value of an option contract. The rest of us don’t need to trade options to find this data useful. The lower market volatility is, as measured by the VIX, the more likely investors are to be complacent. The reverse is also true: When volatility spikes higher, investors tend to be more nervous and wary of committing their capital to what they may view as a riskier asset class.
Over the lifetime of the VIX (as of the date I write this in early 2009), S&P 500 volatility has fallen as low as 10% in early 2007, meaning that at the time, a majority of investors believed the annual return—or the loss—of the S&P 500 wouldn’t exceed 10% in either direction. But in August 1998, at the height of the emerging markets debacle and in the wake of the collapse of Long Term Capital Management, fear drove the index to a record high of 44%, suggesting investors believed that two-thirds of the time, the S&P 500’s annual return would remain within plus or minus 44% (an astonishingly wide range). If you look at those two dates, however, the figures aren’t very surprising. In early 2007, investors were still celebrating the end of a year that had rewarded them with a 15% jump in the S&P 500 and returns that had totaled some 75% over the past 4 calendar years. Not surprisingly, they were pretty content. Of course, as we all came to realize over the next 2 years, there was a lot to worry about just waiting in the wings. The subprime lending debacle was about to explode in the financial markets, economic growth was about to slow, and within a year everyone was worried about the prospect of a recession. A great example of a contrarian indicator at work! The signal worked the same way in 1998; investors were naturally uncertain and even downright fearful that summer after a yearlong slide in the Asian emerging markets followed by that year’s shocking decision by the Russian government to default on its debt payments. Between July 15 and August 30, the S&P 500 plunged 20%, and investor angst ran so high that the stage was set perfectly for a dramatic rebound. The market complied: The S&P surged more than 20% between Labor Day and New Year’s Day of 1999.
Like all data, the VIX is nothing more than a collection of numbers until you find a way to analyze and use the data it gives you. Spotting the contrarian link between volatility and market performance, I decided to try using the VIX as a kind of complacency indicator: The lower the level of volatility, the greater the level of complacency and vice versa. In a study I conducted of the VIX’s behavior between January 1990 and December 2008, I categorized each month-end volatility reading as “high” and the market as nervous if the VIX ran above 25%, “medium” when it hovered between 15% and 25%, and “low” (or complacent) when the index fell below 15%. For every period in which the VIX registered as high, medium, or low levels, my research team and I studied the market’s performance over the following 6 months. The result: The greater the volatility, the higher the returns over the coming months. Indeed, high volatility periods were followed by average monthly returns for S&P 500 stocks of 6.3%. Because volatility tends to peak during the times when financial markets hit rock bottom and the last bulls throw in the towel, that isn’t too surprising. Once the die-hard bulls have capitulated, long-term investors often find the best buying opportunities, just as those of us who were investing two decades ago saw in the aftermath of the 1987 stock market crash.
In contrast, low-volatility periods during which investors bragged about their recent returns and felt unworried about the future of their investments (as indicated by the fact that they didn’t tweak their portfolios much in response to market event events) were followed by an average return of 5.4% over the succeeding 6-month period. Curiously, periods of medium volatility were characterized by the lowest returns in the subsequent 6 months (only 1.7%—see Figure 10.2). Perhaps these represent markets in transition. Obviously, this data isn’t robust enough for you to base your entire investment strategy on it (as indeed you shouldn’t use investor psychology metrics as the basis for your investment process), but it’s a good indicator of what kind of information you can glean from psychology data points.
Figure 10.2 Returns after periods of volatility.
By now, you probably have a pretty good idea of the kind of metric you are looking for in order to incorporate this factor into your decision-making process. You want data that tells you when people are really pessimistic, or at least tells you the degree of pessimism that seems to be in the market. If your analysis of the economy, momentum, and fundamentals tells you that a market is a buy, a great signal confirming that it’s time to hit the buy button and shift some assets into the stock market would be some data showing that other folks out there are feeling grumpy. Almost anything that measures relative levels of pessimism and optimism is fair game. For instance, I tracked the UBS Index of investor optimism on a monthly basis from February 1999 through to the end of December 2007 (when it ceased publication), an index based on survey data that UBS compiled with the help of Gallup based on polls of investors with total savings and investment accounts of $10,000 or more randomly selected across the United States. Yet again, the data showed that higher levels of bearishness were followed by periods of higher returns. The UBS Index may no longer be available to us, but other indicators are. For instance, the New York Stock Exchange monitors the extent to which investors are so bearish about individual stocks that they actually place trades betting that their prices will fall (a process referred to as short selling). Briefly, when investors sell a stock short, they are selling a stock they have “borrowed” from an investment dealer or brokerage firm, hoping or expecting that when they replace that stock it will be trading at a lower price. Let’s say that an investor was able to sell that borrowed stock for $90 a share and buys it back 3 months later for $60. The $30 price difference is profit. The NYSE tracks how much short selling is going on in the stocks it lists and publicly discloses each month the stocks with the largest “short interest ratio.” (That ratio is calculated using the average daily trading volume in the individual stock against the number of shares of that stock sold short.) The result is the “days to cover” ratio, telling us how many days of trading it would take for those bearish positions to disappear if they were unwound.
The stock exchange goes one step further, publishing similar data for all the stocks it lists in aggregate. I have found that a big change in the short interest ratio can correspond to a shift in investor sentiment and foreshadow a change in the market’s direction. As with all other psychology metrics, it’s all about being contrarian: The more short selling going on, the more nervous investors are likely to be. A high level of short interest in the market may signal that all the bears have already succumbed. (That’s a risky bet, requiring a higher-than-usual level of conviction, because if investors get it wrong their downside is potentially unlimited. Think for a moment about what would have happened to our hypothetical speculator of a few moments ago, who sold borrowed stock at $90 a share, only to watch its price soar to $120, $150, or $180! As long as he doesn’t close out that short position by buying back the stock at the new, higher price, his losses on the trade are potentially infinite.) You may recall the way in which Google shares exploded on to the market after their initial public offering. A handful of New York hedge funds, skeptical about the company’s performance (perhaps they remembered what happened to the last batch of high-flying technology stocks), sold Google shares short. It was a painful experience for them. Google’s stock doubled, tripled, and ultimately quadrupled.
A high short interest ratio tells market veterans more than just the fact that the bears are running amok. Rather, it’s an early warning signal that the bulls may be about to return to the fray. In fact, the two species actually become one and the same for a brief moment in time. Once everyone who is bearish on the market has established a short position—driving short interest ratios high—how much new selling is likely to materialize? At that point, paradoxically, the bears represent a source of new buying because, at some point, they will decide to close out their positions and collect their profits. Because closing out those positions means buying the stock, that increased demand can translate into an uptick in the stock’s price as demand exceeds supply. And when the first shorts cover their positions, the upward jump in prices triggers a response among their peers, fearful of being the last to get out of their positions. So they’re likely to react like lemmings and start buying back stock, too, fearful of being caught in what’s known as a short squeeze (defined as the painful position short sellers find themselves in when their bet goes wrong and the stock price climbs rather than falls). No one wants to be squeezed by a bull.
None of the indicators I’m describing here should be used in isolation, including the NYSE short interest ratio. Ideally, you should monitor what is happening with all these metrics and look for a point when they all seem to be generally in agreement about the level of pessimism or optimism in the stock or bond markets. Some of the data sets that I’ve seen people use in the pursuit of an insight into the collective psychology of investors can be tricky to use with any conviction. For instance, buying or selling of stock by insiders (defined by the Securities and Exchange Commission as people likely to have access to privileged information about a company’s business and prospects, such as senior managers and board members) is a favorite tool many investors use to calculate bullish sentiment. The theory is great: Company insiders (who have the most knowledge about the business) will buy when they believe their company’s shares are undervalued and less well-informed investors are underestimating its potential growth in earnings and revenues. But insiders aren’t like other investors. They typically have a lot of their net worth tied up in company stock and get more each year as part of their compensation. So insiders might be selling purely to diversify their own portfolios, pay for their children’s private-school tuition, or to buy a ski chalet in Vermont. Automatically assuming that selling is bearish is wrong.
Most sentiment or psychology metrics apply to the stock market, but other, more specialized sentiment data is available for other markets. Consensus, a sentiment research firm, conducts weekly surveys of money managers on a variety of markets, including crude oil, gold, and silver. Jeffery Weniger, one of my research assistants at Harris Private Bank, studied crude oil sentiment data between April 1985 and July 2004, and rated readings above 75 as bullish, those below 25 as bearish, and those in between as neutral. A familiar pattern emerged. In the wake of a bullish period, crude oil’s price tended to drop 5.6% in the following 6 months. When they were bearish, the average return in the next 6 months was 12%. (A neutral reading was followed by an average 3.2% return.)
The problem you’ll face in dealing with psychology metrics won’t be trying to find enough data. Thankfully, even analyzing it is relatively straightforward, especially when compared to some of the more complex metrics used in connection with other factors. Indeed, any problems you face are likely to be because of the people who generate those data sets, since people are, well, people. Let’s face it, we are notoriously bad at figuring out what we feel and why we feel that way. (How else to explain the popularity of psychiatrists in North America?) In particular, we collectively tend to be very bad judges of how we are going to feel in the future. Myriad studies tell me that I will overestimate how much pain I’ll suffer at the dentist’s as well as the delight I’ll experience during my much-anticipated Mexican vacation. (Perhaps I mentally block out the fact that while the dentist offers pain relief, sunburn and bouts of Montezuma’s revenge can wreak havoc on the best-planned holiday.) As a kid, I was one of the last people in Chicago to see the original Star Wars movie after it opened in the 1970s. By the time I did, I was ready for something extraordinary, thanks to the buzz. Leaving the cinema, I felt let down. Sure, the special effects were impressive, but I never understood what was going on. I’m not alone; studies show that anyone who sees a movie or reads a book before reading a bunch of positive reviews or hearing too many friends’ opinions tends to enjoy it more and rate it more highly. In my experience, the flip side is true as well. Poor expectations tend to set the bar very low. Anyone who decides to flout conventional thinking and attend a film or read a book that received poor reviews is more likely to be pleasantly surprised. Think about this next time the market anticipates a poor employment report from the Labor Department. The lower the expectation, the better the odds are for a positive surprise.
That’s why, tempting as it might be to ignore my advice, I urge you not to succumb to the temptation to use market sentiment indicators such as the ones I’ve shared with you as the primary factor in your decision-making process, much less the only one. Yes, these metrics offer valuable clues into the way investors are thinking, as measured by their behavior in buying, selling, and short selling stocks. But the biggest mistake you can make is to automatically be a contrarian. Although it’s rare to find a market full of bears that is also overvalued, it’s not impossible, particularly in the early stages of a market correction. There’s little that is as painful as finding yourself stuck in a value trap—a supposedly cheap stock (as measured by market psychology or some other metric) that just keeps getting cheaper and cheaper and....
And that is the very reason that fundamentals play such a critical role in shaping any robust investment process.