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Stock-Markets / Stock Markets 2010 Mar 19, 2010 - 03:23 PM GMT

By: Sy_Harding


Best Financial Markets Analysis ArticleInvestor sentiment is a well known indicator of market risk.

For centuries the evidence has been clear that whether it is investing in Barbie Dolls, Beanie Babies, or baseball cards; tulip bulbs, Florida swampland, or oil-drilling rigs; the stock market, art, or houses, investors have no interest in investing when prices are at bargain levels. However, after prices have risen so much that they are creating exciting headlines, investors tend to become frantic buyers at any price to try to catch up and get their share of the gains.

Seemingly, investing is one area where nothing is learned from experience, since the cycle repeats over and over again.

For many decades measurements of investor sentiment have therefore been valuable indicators of risk in the stock market. Once investor sentiment reaches a high level of bullishness and optimism the market is usually at high risk of a serious correction. In the other direction, when pessimism and fear have reached extremes it’s usually an indication that investors have pretty much bailed out of stocks, that selling pressure will therefore abate, and any buying interest at all will likely get the next rally going.

The evidence is clear that the phenomenon remains alive and well. It was seen in the dotcom and high-tech stock bubble of the 1990s, and subsequent severe fear after the 2000-2002 bear market; in the euphoria at the top of the 2003-2007 bull market and extreme fear and belated panic selling of stocks as the March low of last year approached; and in the frantic buying of houses at any price in the housing bubble of 2005-2006.

There are always reasons and rationalizations of why it’s wise to continue buying this time in spite of bloated prices, why this time is different and prices will continue to rise; as well as why it’s wise not to buy at the low prices, why it’s different this time and the economy and market cannot possibly recover from the dire conditions.

But regardless of how compelling the arguments are every time that this time is different, investor sentiment has continued to be excessively bullish at market tops, and excessively bearish at market bottoms, always seeming to work as a ‘contrary’ indicator.

At the present time, my research firm’s work tells us to expect a market ‘pullback’. However, that expectation is not based on investor sentiment, but on the market’s short-term overbought condition, as measured by technical indicators.

Investor sentiment is one reason why we expect only a pullback (of up to 10%) to alleviate the short-term overbought condition, and not the beginning of another major correction, or bear market.

For instance, although there are numerous methods of measuring investor sentiment, and we track all of them, the poll of its members by the American Association of Individual Investors is our favorite. Our research has shown that when AAII members reach a level of bullishness in excess of 55%, and bearishness drops below 23%, the market is usually near a top. In the other direction, when bearishness exceeds 55% and bullishness drops below 23%, the market is usually near an important low.

The AAII poll cannot be used by itself as a market-timing indicator. We combine it with intermediate-term overbought/oversold conditions, momentum-reversal indicators and the like. But the AAII sentiment poll has been an excellent additional tool (which most recently helped us call the market low last March within a few days of the low).

And at the present time the poll is neutral, not close to reaching the excess bullishness that would be a warning sign. This week’s report was that AAII members are 35.4% bullish and 29.9% bearish, with the bullish component having actually fallen from the previous week’s reading in spite of the continuation of the rally.

The large amount of cash on the sidelines can be considered another measurement of investor sentiment. Bull markets do not normally end until the rising prices have not only enticed investors in, but have them very bullish and looking for still higher prices.

Yet a third measurement of the lack of investor interest is the very low trading volume, indicating the market activity that has been driving the market higher has so far been predominantly the activity of short-term traders, including hedge funds, and the large program-trading firms.

So while expecting a pullback to alleviate the market’s short-term overbought condition, I don’t expect such a move would be the beginning of a serious correction, or new bear market, but only a ten percent pullback, with the bull market resuming until investor sentiment reaches an extreme of bullishness.

A serious decline is more likely to begin a couple of months down the road when the market’s favorable season ends, as in ‘Sell in May and Go Away’.

Sy Harding is president of Asset Management Research Corp, publishers of the financial website, and the free daily market blog,

© 2010 Copyright Sy Harding- All Rights Reserved

Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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