Every Summer, thrill-seekers from around the world descend upon the streets of Pamplona, Spain, to run with the bulls. This centuries-old tradition may provide a shot of adrenaline and a story for a lifetime, but it can also leave participants battered and bruised, or worse. Consider this a proxy for those times when everything and everyone in a market seems to be going the same direction. Consider also that the “crowd” is often wrong, especially at major market turning points.
Contrarianism has long been debated and employed in various ways in the investing world. But it’s one thing for a deep-pocketed hedge fund titan to bet against a company’s shares by building a large short position. Just how does an individual investor quantify and act on this complex subject? Fortunately, there are several tools that can offer guidance for when optimism or pessimism reaches extreme levels and can help you make coolheaded, logical decisions.
We’re all human, of course, so you’re not alone if you find yourself on an emotional bungee cord as you pore over your charts and account statements. Some days, you might experience thrills, agony, and other brainbenders in just the few hours between the opening and closing bells (see figure 1). Markets move in cycles over the long term, with extreme sentiment and behavior often boiling over at key turning points. You can’t control any of that. But consider the following to help you check your head.
Known as the “fear gauge,” the CBOE Volatility Index (VIX) is among the most widely followed sentiment readings for U.S. equities. It’s based on options contracts linked to the Standard & Poor’s 500 Index, and measures volatility expectations a month into the future. Historically, high volatility periods, and thus a high VIX, have coincided with broader market bottoms. That reflects a rush to buy put options, which offer a measure of protection for a limited period of time against falling prices.
“When the VIX rises, it tells you people are buying puts on the S&P 500, which means they are becoming fearful of a market pullback,” said Brett Pattison, Educational Resource Manager with Investools®, the education affiliate of TD Ameritrade. “They are looking for protection.”
Conversely, low-volatility periods can correspond to market tops. Over the summer, the VIX slumped to the lowest levels in over seven years as the S&P 500 notched record highs, suggesting investors aren’t particularly skittish over anything—for now. A VIX in the 10–13 range—where the index was for most of the summer—is considered historically low.
On the high side, a VIX at 25–30 reflects elevated uncertainty, and—remember, we’re talking about contrarian signals—might actually indicate a market bottom is forming (the index was 12.09 at the end of August). Plotting the VIX alongside the S&P 500 may reveal turning points (see figure 2).
Investor polls are also worth eyeballing. The American Association of Individual Investors (AAII) conducts a weekly sentiment survey that measures the percentage of respondents—largely retail types— holding bullish, bearish, or neutral stock market outlooks for the next six months (see figure 3)
Much like the VIX, survey-based readings should be viewed in a backwards fashion, meaning high levels of bullishness or optimism could be a warning that a market top is forming, while extreme bearishness or pessimism may signal a bottom. Investors can plot the data as a four-week moving average to help smooth out the readings. A move toward 52-week highs or lows can highlight possible inflection points.
Knowledge: An Important Tool
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When everyone in the crowd is doing the same thing, and sentiment appears to be extreme, it’s often prudent do the opposite. But this doesn’t mean the longer-term trend is finished—maybe it’s just a temporary pullback or rebound. There are other factors to consider as well.
Contrarian tools can indeed be an early warning alert system that the trend is changing. But nothing is fool-proof, and there may also be a time lag between an extreme reading and a market turn. That’s why it’s important to look to other technical indicators for confirmation and entry signals.
“Sentiment is best used as a heads-up,” said Jason Goepfert, President of Sundial Capital Research. “An extreme can always get more extreme. It’s about increasing your odds and potentially decreasing your risk. Don’t use sentiment in and of itself. It’s one piece of a total form of analysis.”
The Bottom (And Top) Line
Keep in mind that trying to call turning points, however rock-solid your indicators appear to be, is a dangerous game. To cite an ancient Wall Street axiom, the market can stay “wrong” longer than you can stay solvent. Still, it’s wise to be constantly asking whether you’re maybe a bit too much with the in crowd, and whether it’s a good time to take the road less traveled.