Market Sentiment

Many of the world's greatest investors have monitored market sentiment, using their findings to identify major market turning points. Here we look at some of the key signs that a sentiment-driven market may be about to turn. At these times great wealth can be acquired or lost.

Sentiment analysis tries to determine whether the market has grown unreasonably bullish or bearish and whether it's time to bet against the market crowd. Analysis of this kind is the basis of contrarian investing.
mr market

Most times it's unwise to bet against the crowd - it's usually profitable to be on the crowd's side. When the crowd grows extreme, however, it's time to switch sides. Contrarians try to identify the times when the crowd has turned extreme and hence identify market-extremes. Taking the right side in such circumstances is a rare opportunity to comprehensively beat the market.

A number of well-known investors have made (or saved) fortunes by taking a contrary view at crucial times:
  • Warren Buffett dissolved his investment partnership in 1969, returning cash to investors. He could find no worthwhile investment opportunities and believed that the market was overvalued. 1970 saw a big fall in stock prices from those in 1969. In fact the whole of the early 1970s were terrible for stock investors. At its lowest value in 1974 the Dow Jones Industrial Average had fallen 40 percent from its highest level in 1969.

  • Martin Zweig predicted the crash of 1987 and his portfolio rose by 9 percent on Black Monday while the broader market fell by almost 23 percent.

  • In 1999 and again early in 2000, Sir John Templeton predicted a market crash on the scale of the great crash of 1929.

  • Joe Kennedy sold out of the markets a few months before the crash of 1929. He sold after a shoeshine boy gave him a hot tip for the stock market. Kennedy realized that if the market had been bought to the extent that even shoeshine boys were buying stocks, it was time for the smart money to move in the opposite direction. Kennedy did just that and profited by selling the market short.
Although only Joe Kennedy's explanation of his actions was entirely sentiment-based, Warren Buffett, Martin Zweig and John Templeton have all spoken about market sentiment and the need to bet against the crowd when the crowd is behaving in an extreme manner.

In Memoirs of Extraordinary Popular Delusions and the Madness of Crowds, first published in 1841, Charles McKay recounts the history of three extreme markets:
  • The Tulipomania of the 1640s
  • The Mississippi Scheme of the 1720s
  • The South Sea Bubble of the 1720s
At the height of each mania, the stock or commodity in question traded at enormously inflated prices before plunging in value, destroying the savings of many small investors. Although we might like to think that we are more sophisticated than our forebears were, it's clear from the .com bust of Y2K that we are just as prone to excess as they were. Thankfully, manias such as these are relatively rare.



Mr. Market

It was Benjamin Graham who first introduced investors to the manic-depressive Mr. Market. Warren Buffett has since taken up the cause of his late mentor and is fond of mocking - and profiting from - stock market excesses. According to Buffett, the wonderful thing about Mr. Market is that, whatever his mood, he is available every day to quote stock prices. Buffett is more than happy to take advantage of this contradictory character.

It's important to state that Mr. Market usually behaves quite rationally, buying and selling stocks at reasonable prices. Occasionally, however, his manic-depressive tendencies take over. These are the times when Mr. Market offers patient and courageous investors the best opportunities to obtain outstanding returns from the stock market.

When Mr. Market becomes unreasonably optimistic, he will buy your stocks for more than they are truly worth. You should sell your stocks to Mr. Market at these times.

When Mr. Market is unduly pessimistic, he will sell you his stocks for less than they are truly worth. You should buy stocks from Mr. Market at these times.

Picking a turning point in the market, however, can be difficult. Even after we have come to believe that a market is overvalued, it may still rise to much greater heights before the inevitable crash follows. Similarly, undervalued markets can remain depressed for many months or even years before rising again to something like fair value.



How To Measure Whether
The Market Has Moved Too Far In One Direction

Seasoned analysts have several ways of determining whether sentiment has carried the market too far in one direction. By too far I simply mean that a change of direction is likely.

Basic signs of an overbought market are:
  • The market is reaching new highs.

  • The vast majority of investors are optimistic about the prospects of further rises.

  • News that would normally cause the market to fall has no effect while good news causes further rises.

  • Authors fall over one another to publish new books about stock investing.

  • There is a rush of IPOs (Initial Public Offerings, i.e. companies listing on the stock market for the first time) as entrepreneurs rush to cash in on the public's appetite for stocks.

  • Mutual funds will have less cash than usual because a higher proportion of their capital will be invested in the market than usual.

  • Most people are fully invested in the market - there will be little extra money available to push the market to new heights.

  • The average guy in the street wants to talk about the stock market more than football.

  • People who have not bought stocks will be told that they are missing a fantastic opportunity.

  • A few crusty fundamental analysts will have been grumbling for some time that stocks are historically overvalued, but little attention will be paid to their gloomy prognostications - they will probably be accused of crying wolf and possibly ridiculed.

  • Newspaper commentators and market-newsletters will have reached unusually high levels of optimism. They will be almost unanimous in the opinion that you need to have your money in this market.

In these circumstances history indicates that a large fall in prices is likely.

Basic signs of an oversold market:
  • Following a succession of new market lows, people will be holding back cash, unwilling to expose it to further losses.

  • News that would normally cause the market to rise has no effect while bad news causes further falls.

  • Newspapers will be talking about the financial crisis, showing charts of the market making new lows.

  • Market commentators will be speculating about just how low the market could go and the dreadful consequences if their speculations became reality.

  • The number of people who have sold their stocks and who are sitting on the market sidelines is such that there will be a huge reserve of cash available for stock buying, but only after people start to believe the crisis had reached its worst point.

  • The guy in the street runs a mile if you try to give him some stock tips.

  • Mutual funds will have more cash than usual because a lower proportion of their capital will be invested in the market than usual.

  • A few crusty fundamental analysts will be drawing attention to how seriously undervalued many stocks are and snapping up blue-chip stocks at bargain prices. Very few other investors, however, will be brave enough to follow their lead.

In these circumstances history indicates that a new bull market may be just around the corner.

Learning to identify the worst excesses of the market helped investors like Warren Buffett, Martin Zweig, Sir John Templeton and Joe Kennedy to enjoy great success. The ability to take a contrarian view at the right time should be considered a vital weapon of the armory of anyone who wants to beat the market.