It is said “the crowd is right during the middle and wrong at both ends” of important moves in the investment markets. The common interpretation of this popular Wall Street cliché is the crowd, which is usually equated to the general investing public, is “dumb” and is never ready for a move in the market.
However, history shows that the “crowd” is usually “right” for the vast majority of a big move, but “wrong” when the crowd reaches extreme levels of either optimism or pessimism. Thus, the cliché should probably be amended from “beware of the crowd” to “beware of the crowd at extremes.”
The basic premise behind the analysis of investor sentiment is when investors/traders/fund managers say they are bullish, they either are or have been in the process of buying. And in essence, it is this buying that drives the market higher. In turn then, when investors are bearish, they are likely in the process of selling. It is for this reason that the crowd is “right during the middle” of most trends.
While the analysis of investor sentiment tends to be more art than science, a great many analysts like to issue warnings when the crowd becomes bullish or bearish. The key though is to determine the difference between when the crowd is bullish and extremely bullish as well as the difference between bearish and extremely bearish.
In addition, it is vital to understand that a change in the prevailing trend usually requires a trigger or a catalyst. Remember, “A trend in motion tends to stay in motion.” And despite the fact that the crowd may be wildly optimistic (or pessimistic), trying to trade on this data alone can be akin to stepping in front of a speeding train. So, don’t forget another oldie, but a goodie, “Markets can remain irrational longer than you can stay solvent.”
Contrary to popular belief, just because a trend is popular does not make it bad. And just because most investors have become bullish doesn’t mean a market is ready to fall. For example, stocks were quite popular from 1989 through 1999. But if you had bailed out just because the crowd was behind the move, you would have missed an awful lot of profit potential.
However, once the crowd has reached either a bullish or bearish extreme, it is important to understand that investors have already taken their positions, leaving little demand left for buying or supply left to sell.
So, how do we determine when the crowd is at an extreme level? By plotting the data on a chart, of course, and then looking back at history.
Tracking the Data
One of the easiest ways to track the mood of investors is to monitor the weekly data released by Investors Intelligence. The percentage of bulls, bears, and those looking for a correction, is the granddaddy of sentiment data and is readily available. Even CNBC reports the data every Wednesday. So, if you don’t have access to a lot of sophisticated research, simply tune in each Wednesday and jot the numbers down when they flash across the screen.
Going back to 1970, history shows that there are clearly defined levels of bullishness and bearishness that it has paid to heed. The good folks at Ned Davis Research tell us that if you take the number of bulls divided by the number of bulls plus bears from the Investors Intelligence data, and then average it out over a 10-week period, you will get a pretty good picture of when the crowd reaches extreme levels.
Trading Sentiment Indicators
History shows that when the 10-week average of bulls/bulls+bears is above 69, the Dow Jones Industrial Average has actually lost ground. This tells us that when approximately 70% of investors have been bullish over a two and one-half month period, things are becoming a little frothy and that the move is getting long in the tooth.
The real trick to getting the sentiment game right is to recognize that once “the crowd” reaches an extreme level and then reverses, it is time to think about going the other way. For example, if you sold out of the DJIA after the 10-week average of bulls/bulls+bears went above 67% and then dropped below 67%, you could save yourself a lot of money.
Using a strategy of buying after the 10-week average moves above either 42% or 59% and then selling when the average crosses below 67% has proved pretty darned profitable. Since 1970, 93% of the trades would have been closed out with gains and your average annual
