5 Ways to Gauge Market Sentiment

1) Sentiment Surveys:

a) The American Association of Individual Investors Sentiment Survey measures the percentage of individual investors who consider themselves "bullish," "bearish" or "neutral" on the stock market on a weekly basis. The AAII indicator is considered a contrary indicator because individual investors like you and I are considered “last to know”. It has been found that the significance of the AAII Index Ratio increases as it rises above 70% or falls below 30%. Hence when the indicator is overbearingly bullish or bearish it is usually a signal for change in market sentiment. Available here: http://www.aaii.com/
b) The Hulbert Stock Newsletter Sentiment Index (HSNSI) tracks the recommendations of a number of financial newsletters and reflects the average recommended stock market exposure among a subset of short-term market timers tracked by the Hulbert Financial Digest. Hulbert regards HSNSI as a contrarian signal for future stock returns; so when HSNSI is high, he views the outlook for stocks as generally bearish and vice versa. The HSNSI is only available to paid subscribers but if you keep an eye out on http://www.marketwatch.com/ or type “Hulbert Stock Newsletter Sentiment Index” into Google, you can invariably find someone blogging or commentating on the latest HSNSI readings.
c) Lastly, one can also use the readings of the Yale Stock Market Confidence Indexes to gauge market sentiment. Available here: http://icf.som.yale.edu/confidence.index/YearIndex.shtml?



2) IPO Volume and First Day Returns according to Sector: During the first quarter of 2007, IPO volumes in the U.S. hit a seven year high in terms of both volume and proceeds, with $12.1 billion raised through 64 IPO’s, up from $11.6 billion from 54 IPOs in Q1 2006, but down from $19.7 billion from 89 IPO’s during Q4 2006. Average deal size has fallen to $190 million from $216 million and $221 million during Q1 and Q4 2006, respectively. The average first day returns for IPO’s in the United States in the first quarter of 2007 was 8%. These statistics are important to consider because I think IPO volume and first day returns for IPO’s signify investor appetite for new public issues and how bullish businesses feel the markets are. In my mind, a business would only go public if it thinks it is the most opportune time in the market to do so and evidence of this can be gleaned from first day returns on IPO’s. I also think that higher first day returns for IPO’s demonstrate investors’ appetite for greater risk (which translates into bullish sentiment). Let’s take for example the year 1999, investor bullishness for technology IPO’s regardless of company specifics was so great that they pushed the average first day returns for IPO’s to 72%, compare that to 11% last year (2006). So if you see IPO volumes suddenly rising significantly compared to prior period and first day returns suddenly rising much higher than usual it usually signifies a market top and vice versa.




3) VIX, VXN and VXD: The VIX is the ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market's expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options. This volatility is meant to be forward looking and is calculated from both calls and puts. The VXN is the ticker symbol for the CBOE NASDAQ Volatility Index and the VXD is the ticker symbol for the CBOE Dow Jones Industrial Average Volatility Index. Since all 3 volatility indexes move in the opposite direction (inversely) to their corresponding benchmark indexes [VIX moves inversely to S&P 500 index, VXN moves inversely to Nasdaq 100 index (NDX), VXD moves inversely to DJX, which is the symbol for options based on The Dow Jones Industrial AverageSM, observing the price movements of the VIX, VXN and the VXD can give one insight into what direction the market is trending by analyzing what investors’ eagerness for risk and volatility are.




4) Bullish Per Cent Index (BPI): The BPI is a popular market breadth indicator that is calculated by dividing the number of stocks in a given group (an exchange, an industry, etc.) that are currently trading with Point and Figure buy signals, by the total number of stocks in that group. The BPI is a contrarian indicator and hence when market bullishness as indicated by the indexes are too high, it is proably a good time to go short and vice versa. When the BPI rises over 70, it is considered overbought (i.e. time to go short the corresponding index) and when the BPI falls below 30, it is considered oversold (i.e. time to go long the corresponding index). There are BPI’s for the NYSE ($BPNYA), the NASDAQ Composite ($BPCOMPQ), the Dow Jones Industrial Average ($BPINDU) and the S&P 500 ($BPSPX).
Since the BPI applies to groups/sectors of stocks it gives an investor a more general, broad based view of markets from an overbought/oversold standpoint.



5) Fund Inflows: Keeping an eye on where investors and putting their monies can be a great contrarian indicator of market sentiment. In a study done by 2 economists, Andrea Frazzini from the University of Chicago Graduate School of Business and Owen Lamont from the Yale School of Management which examined mutual-fund inflows from 1980 to 2003, they found that “for every period longer than three months (and out to five years), the stocks receiving the highest flows of new mutual-fund money performed significantly worse than the stocks that received the lowest flows of new money. Over a three-year period, the difference was 8 percentage points a year. In other words, individual investors had lousy timing, and their efforts to chase returns ended up costing them dearly. As a result, the authors conclude that "individual investors in aggregate are unambiguously dumb." (Excerpted from a Daniel Gross article “Why You Are Dumb Money”)
For example, if I see a trend (over a few weeks or months) where fund inflows into equity mutual funds are decreasing significantly and fund inflows into bond/money markets funds increasing significantly, I might start bulking up on some of my equity positions. In a sense, I would invest conversely of what the fund inflows data tells me.
Resources for Fund Inflows:
Investment Company Institute http://www.ici.org/
Amg Data http://www.amgdata.com/

In conclusion, there are many more sentiment indicators out there but I have chosen to write about the ones I use most often. I use sentiment indicators as a tool to gauge whether I should be long or short the markets and specific sectors. I can and often will be wrong in the short term however, I am looking to outperform the market in the long term on a relative and absolute basis. The resources I have provided above have helped me a significant amount and I hope they do the same for you. Happy and Successful Investing.