Unmasking The VooDoo: Sentiment

Usually, when I discuss the major parts of technical analysis I'll use an analogy of a table. Price is the top of the table and the most important part. The legs are volume, time and sentiment. They support price analysis but do not supplant it.

Everyone gets price from patterns to trends to momentum. Everyone get volume. Most people get the concept of time, too, which includes such things as cycles, analogs and some esoteric stuff such as Gann.

But sentiment is often the red-headed stepchild of the analysis. Sentiment is hard to gauge. It is hard to quantify. And it is usually fairly hard to gather. Just look at your charting software list of studies. You'll see RSI and cumulative volume. You might even see an Elliott Wave "recognizer" but you are not likely to see something called sentiment.

These things do exist but they are not derived from trading as all the other parts of the table. Sentiment is the true oddball of technical analysis because it is the only analysis that seeks to figure out what traders are thinking. It's not like everyone inputs their feelings into an app on their screens and sends it off for tabulation at a vendor.

Yes, I know there are surveys that do just that but for every collector of sentiment there is a different method and interpretation.

And there are many, many different types of surveys and proprietary indices. There are surveys of traders, of investors, of newsletter writers. Then there are surveys of the actions of traders, which are different from surveys of what traders think. There are surveys of money managers and of Wall Street strategist equity allocations.

There are a few oddball things such as the trend of carpenter tool prices and railroad car usage. Most people may have heard of the trend in oil rig counts.

Have you heard of the hemline indicator? They get shorter when people feel feisty and good.

How about the magazine cover indicator? This is a real thing and it is actually pretty good. 

The ratio of football revenue to baseball revenue? Football is a darker sport. Baseball seems to do well when people are happy. Just ask George Carlin what he thinks about these two.

How about horror movies vs. romantic comedies? Same logic.

Giving credit where it is due, those last two come from socionomics, which looks at social mood as an indicator of the stock market. It actually works in reverse but they are closely enough correlated for this discussion. 

And if that were not enough, there are a few things that are generated from trading including the famous VIX index, which is concocted from options prices. There is the ratio of puts to calls. Of put volume to call volume. Of equity only puts and calls. Of index puts and calls.

I supposed if we go there it is not far to include the number of stocks above their 200-day averages and at new 52-week highs or lows.

Have I convinced you that sentiment is wild and whacky? And hard to quantify? And hard to even obtain the data?

Using Sentiment 

Let's assume you have access to some sentiment data or perhaps just have eyes and ears to follow the news.  What do you do with it?

First of all, you have to understand that sentiment is a contrary indicator. And most of the time it tells you nothing useful. If the market is going up then sentiment should be happy. 

It is similar to the trend is your friend until the end. Most of the time, the crowd is actually right and you follow along. Only at the extremes is it wrong and you need to go against it. You know, buy when there is blood in the streets. Sell when E*Trade runs ads with cab drivers buying islands. Or when the local pizza shop owner brags about how many houses he flipped.

Remember way back to 2008 when the market was going to hell in a hand basket? It was a brutal bear market and the government was panicking to do something - anything - to look like they were able to stem the tide. My father-in-law, rest his soul, called me to sell everything in his portfolio. I sold a little so he would not be mad at me but I kept the rest.

When the public gets so scared that they throw in the towel you know sentiment is at an extreme for bearishness. In fact, the American Association of Individual Investors survey was at a record high for bearishness. Something like 70% vs. its historical 28% (I am just going from memory on those stats).
 

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Disclosure: No positions in anything covered.

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