market

Michael Lewis wrote the following on contrarianism in his classic book on a market,  “Liar’s Poker”.

Everyone wants to be, but no one is, for the sad reason that most investors are scared of looking foolish. Investors do not fear losing money as much as they fear solitude, by which I mean taking risks that others avoid. When they are caught losing money alone, they have no excuse for their mistake, and most investors, like most people, need excuses. They are, strangely enough, happy to stand on the edge of a precipice as long as they are joined by a few thousand others…

Contrarianism is one of the most abused platitudes in trading and investing. Everybody thinks they’re a contrarian, but few actually are.

And that, by its very nature, has to be the case. Because to be a contrarian is to go against the herd, the majority. It is to take the opposing side of popular sentiment.

Hedge-fund legend Ray Dalio put it like this, “You can’t make money agreeing with the consensus view, which is already embedded in the price.”

But how does one know what the consensus view is? How does a contrarian properly measure market sentiment so he can act as an effective contrarian and not someone who just ignorantly jumps in front of market freight-trains?

The answer is to use a number of quantitative tools that are void of bias and simply present a measure of the aggregate sentiment of the market. In this piece, we’ll cover three of the most important sentiment gauges that are free and widely available to the investing public. By the end of this article, you’ll know how to properly measure market sentiment, understand what the prevailing consensus is, and as a result invest in markets as an effective contrarian.

Let’s begin…

The three best — and free! — tools for measuring market sentiment are:

  1. AAII Investor Sentiment Survey
  2. CNBC Fear & Greed Index
  3. CBOE Equity Index Put/Call ratio

We’ll start with the first and go down the list.

  1. AAII Investor Sentiment Survey

The AAII Investor Sentiment or AAII Bull-Bear Survey has been an investor staple for getting read on market sentiment for decades now. It’s a weekly survey that’s put together by the American Association of Individual Investors. The survey simply measures the percentage of individual investors who are bullish, bearish, and neutral on the stock market over the short-term. Participants are polled on the AAII website on a weekly basis.

You can find the survey’s latest results (for free) on the AAII’s website here. You can also find AAII sentiment data widely available on a number of free charting software, including Tradingview, Stockcharts, and many brokerage services.

A chart of the AAII Bull-Bear data looks something like this.

The way to read this indicator is as a contrarian. So you want to look out for readings showing extremes in either bullish or bearish sentiment. As you can see on the chart, those often mark major turning points in the market.

Bull markets climb a wall of worry and bear markets fall down the stairs of hope. So if you’re bullish and buying the market, you want to see either a bearish or mostly neutral reading from AAII. When the indicator hits an extreme, you want to start taking profits and moving up your stops.

  1. CNBC Fear & Greed Index

The CNCCFear & Greed Index is a composite sentiment and positioning indicator that updates daily. You can find the indicator and its components on its website here. The indicator is comprised of what CNN calls its “Seven Fear & Greed Indicators”. These include:

  1. Market momentum
  2. Stock Price Strength
  3. Put & Call Options
  4. Safe-Haven Demand
  5. Stock Price Breadth
  6. Market Volatility
  7. Junk Bond Demand

The indicator is illustrated in both graphical and chart form as shown below.

Similar to the AAII indicator, you want to read these as contra signals. You want to buy when “extreme fear” is in the market and sell when “extreme greed” is prevalent.

  1. CBOE Equity Index Put/Call ratio

One of the most effective sentiment indicators is the CBOE Equity Index Put/Call ratio. CBOE stands for the Chicago Board of Options Exchange. This indicator shows the actual buying and selling of index call options within the market, and thus is a reflection of broader market sentiment. Investors buy puts when they’re worried (bearish). They buy calls when they’re greedy (bullish). The ratio between these two gives you a glimpse into market psychology.

Now, this indicator is noise as in it jumps up and down from day to day. So it’s best to smooth it out with the moving average (we prefer the 10-day average). You can find this data on any basic free charting software. Here is an example of what the CBOE Put/Call chart smoothed with a moving average looks like.

A high reading means investors are buying lots of puts relative to calls, and are bearish. Vice-versa when the indicator gives a low reading.

Now, none of these sentiment indicators is a panacea. They won’t work all the time and often there’s a lag between a sentiment extreme and a market response. No perfect indicators exist… But if used in conjunction with one another and within a solid investment process, these indicators of market sentiment are invaluable. They’ll help inform you when you should be buying aggressively and when to pare down risks.

As Buffett said, you want to “be greedy when others are fearful and fearful when others are greedy”. These indicators of market sentiment will help you do just that.

Johny Lablank has been a professional investor with a focus on value for over 13 years, spending his time in small to micro-cap companies. Macro Ops is a market research firm geared toward professional and experienced retail traders and investors. Johny has a tenacious passion for investing, capital allocation, and business.

Market stock photo by tanatat/Shutterstock