Overview

The basic idea behind the sentiment indicator is that when the crowd turns overly bearish, it’s a bullish indicator and vice versa.

Of all my indicators sentiment is the most difficult to assess and, in my opinion, the least valuable. I can’t actually define how I gauge sentiment because it is far more art than science. It’s about getting to know lots of people of various leans, both bullish and bearish, what their normal tenor is and continually monitoring them.

It’s also about reading my own sentiment! Pretty much everyone who actively invests or trades believes that they are smarter or more skilled than the crowd. They believe this right up until they have lost most of their money and panic too. This is because trends tend to go so much further than we think they should even after sentiment seems to have gotten extremely bearish or euphoric.

I’ve always said that real panic isn’t when others are panicking, real panic is when you are panicking, and for completely legitimate reasons.

Sentiment tends to trend in the following way. Let’s take a bull market. First, a small set of people turn bullish while the preponderance of evidence is bearish. Then more people jump onboard but you remain skeptical. As the market rises and news gets more and more positive you give in and start turning bullish. Again, the news flow is great and the outlook extremely positive and everyone seems to be making more money than you. You decide to buy and make some money and you turn more bullish and believe the bullish narrative. This is when you need to be cautious from a sentiment standpoint.

But sentiment is extremely tricky because what’s extremely bullish can get outlandishly bullish and from there enter the zone of insanity and from there still have years left in the bull market.

Sentiment is also the indicator that I’m most comfortable gauging and tempted to overweight and default to as the most important. So I have to make sure to remember that it is just one indicator and not the most important.

I do not believe in widely dispersed sentiment surveys like the CNN Fear and Greed index. It’s overly simplistic and I believe you need empathy and to understand people at a deep level to really understand sentiment. The NAAIM survey is a decent indicator but only when it has extreme readings. By definition extreme readings don’t happen all that often.

To me sentiment gets to be extreme when everyone- those who are typically bullish and those who are typically biased to the bear side- are leaning the same way. One side gets extremely confident and euphoric while the other side sort of capitulates and throws in the towel. Then you are at an extreme.

One other very strong indicator is when bulls (or bears as the case may be) gain a large degree of hubris. The market always punishes people who believe they are superior to everyone else. When I start to see signs of that it’s a fairly reliable fade.

I think that the market is like a wave that is going back and forth at various frequencies and individuals have a frequency with a very narrow range. At brief times the market’s frequency overlaps with theirs and they do well. Eventually the market’s frequency changes and they stay the same or become more entrenched and miss the next market phase which rewards people at a different frequency. Sounds strange but I am certain nobody, no matter how smart or how consistent their track record, consistently outsmarts the market. The best do well then figure out when the risk/reward is no longer in their favor and aim to preserve capital.

So I sum up my sentiment reading on the following scale:

  • Extremely bearish (strong bullish indicator)
  • Moderately bearish (weak bullish indicator)
  • Neutral
  • Moderately bullish (weak bearish indicator)
  • Extremely bullish (strong bearish indicator)

Anywhere between moderately bearish and moderately bullish just means I’m getting mixed readings and don’t have a strong signal. This is going to be the case the vast majority of the time.

Extreme readings almost always come at times of extreme price movement, either up or down when the market is extremely oversold or overbought. People tend to get the most scared or excited at the worst times tactically.