Trying To Solve The Sentiment Conundrum

[This post is a modified excerpt from a recent TSI commentary]

In a 12th June blog post I revisited the potential pitfalls in using sentiment as a market timing tool. As an example of a pitfall, the post included a chart of the Investors Intelligence (II) bull/bear ratio suggesting that US stock market sentiment had been consistent with a bull-market top for the bulk of the past four years. Even though the chart helped to make my point it is appropriate to question how sentiment, when used as a contrary indicator, could be so wrong for so long.

I’ve come up with a possible explanation for why measures of US stock-market sentiment that worked well as contrary indicators in the past have not been useful of late. The reason relates to the third of the potential pitfalls outlined in the above-linked blog post. Specifically:

“…regardless of what sentiment surveys say, there will always be a lot of bears and a lot of bulls in any financial market. It must be this way otherwise there would be no trading and the market would cease to function. As a consequence, if a survey shows that almost all traders are bullish or that almost all traders are bearish then the survey must be dealing with only a small — and possibly not representative — segment of the overall market.”

The explanation I’ve come up with is that prior to the past few years the II sentiment survey, which is a survey of investment advisors who regularly publish their views via newsletters, reflected the sentiment of the investing public, but this is not so much the case anymore. Prior to the past few years the advisors and the general public would become increasingly bullish or increasingly bearish together, with high levels of optimism invariably following persistent price strength and high levels of pessimism invariably following either persistent or dramatic price weakness. Over the past few years, however, the perceptions of these two groups took separate paths. Investment advisors became very optimistic in reaction to the strong upward trend in prices, but for the most part the general public remained unenthusiastic about the stock market.