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How sentiment measures can help in formulating investment strategies

by John Kosar | Oct 12, 2016 | Proactive Advisor Magazine |

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Investor sentiment metrics provide valuable insights on what the “investment crowd” is thinking, often helping to identify important market tops and bottoms.

As an analyst with 35 years of experience who makes a living by forecasting the future direction of financial asset prices (with a goal of finding opportunities before the rest of the world catches on), I look at virtually every category of analytical tool imaginable.

There are many technical metrics—including moving averages, trend lines, and momentum gauges—that investors can use to quantitatively determine when a price trend begins and ends. The limitation of these metrics is that they are typically lagging indicators. By the time it becomes apparent that the trend has changed, the price of the asset has already made a significant move in the opposite direction.

Investor sentiment metrics, however, can tell us what is happening inside the market during that price trend—that is, the quality of the trend. Asbury Research tracks a robust and diverse group of these more qualitative investor-sentiment indicators and separates them into two categories: survey-based and asset-flow-based metrics. I acknowledge that by strict definition investor asset flows may not fit into the investor sentiment category, but I have found that when combined with survey-based measures, they can collectively provide a more robust, comprehensive, and accurate way to view investor opinion and how it is likely to influence the direction of asset prices.

Importantly, most of these metrics are contrary indicators. This thought is based on the assumption that the vast majority of investors are typically “the most wrong” about price direction at the major market turns. That is, asset prices typically peak when investors are collectively the most bullish and bottom when they are the most bearish. Of these two types of metrics, I have found that the asset-flow-based metrics are generally more sensitive, accurate, and useful, because they are based on investors with real money at stake in the market. Opinions can change free of charge, but real assets invested force investors to decide, every day, whether or not to remain in the market.

That being said, I have found that tracking a large and diverse group of sentiment indicators, looking for corroboration and confirmation, provides useful depth and color on the market. While it is a labor-intensive exercise, it is well worth the time invested. Eight investor sentiment metrics that I track every week are presented below, along with a brief description and commentary on how I integrate them into my investment strategy thinking.

Survey-based indicators

NAAIM Exposure Index

The NAAIM (National Association of Active Investment Managers) Exposure Index is a weekly survey that represents the average exposure to U.S. equity markets as reported by the association’s membership. I have found this survey to represent an intermediate-term perspective, which I define as being one to two quarters in length.

Figure 1 plots the NAAIM Exposure Index (lower panel) and the corresponding weekly chart of the S&P 500 (SPX) (upper panel). I have defined 85% and 14% as the most bullish and least bullish extremes in the index based on the range of the survey during the past decade.

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FIGURE 1: NAAIM EXPOSURE INDEX VS. S&P 500

The red highlights show that every meaningful peak in the SPX since 2006 has coincided with a most bullish extreme in the survey, while the green highlights point out that the least bullish extremes have coincided with every meaningful bottom. The chart also shows that there were many instances, especially the most bullish ones, that did not correspond with a significant U.S. broad market peak. This is precisely why I take the time to look at a number of similar but different metrics to try to find a collective message in the data, rather than relying on any one of them to identify a potential market top or bottom.

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