To achieve a quick sense of the balance of power in the market, a technical trader may often wish to lay aside the charts and graphs for a time and examine other information to gain an overall perspective on the bulls and the bears. A common and widely accepted means of ascertaining this balance of power is to take a quick reading of a sentiment index, the most prevalent of which is the Investors Intelligence reported figure, which is published by Chartcraft.
In actuality, the Investors Intelligence sentiment index may refer to one of several possible sentiment indicators, including an advisor sentiment review and an insider activity review. These individual indexes are grouped according to representative sectors of market participants. For example, market advisors are seen to possess a certain level of insight into possible market direction that may differ from that of economists or, worse, the "talking heads"are a continuous stream of market commentary from the business cable channels. In the same vein, a sense of sentiment can be gained from insider activity, which shows the actions and feelings of a director of a public company. This sentiment is then used to ascertain the potential returns from that company's stock.
When we refer to the Investors Intelligence sentiment index, we are generally talking about advisor's sentiment, which is a culmination of the forecasts of the newsletter writers. The newsletter writers issue independent advice from their publications and commentary. Chartcraft studies more than 100 such newsletters for deriving the Investors Intelligence Sentiment Index.
The Investors Intelligence sentiment index is based on contrarian propositions, according to which equity traders should act opposite to the balance of expert opinion. The sentiment indicator assumes that a consensus trend is always about to reverse, providing traders with the opportunity to capitalize on an imminent reversal in price movement. The signs of a reversal are strongest when the balance of opinion is strongly skewed in one direction.
Academic Research and Investor Sentiment
Although the famous Investors Intelligence index was created in the 1950s and refined in the 1960s, it was not until the turn of the 20th century that the index was put to a rigorous test. In the years leading up to the year 2000, writers from the University of Santa Clara conducted a study, written by Ken Fisher, CEO of Fisher Investments, and Meir Statman, the Glenn Klimek professor of finance at Santa Clara University. Their study demonstrated only a weak correlation between the Investors Intelligence Sentiment Index and major market turning points. The study concluded the following: "We found the relationship between the sentiment of newsletter writers as measured by the Investors Intelligence survey and future S&P 500 returns to be negative but not statistically significant," (published in the Mar/Apr 2000 issue of Financial Analysts Journal).
It is for this type of criticism that Investors Intelligence clarified the purpose of its indicator, at the same time giving a good illustration of exactly what investor sentiment is and, perhaps more importantly, what it is not. Most notably, like any other indicator, the sentiment index usually tells you nothing - most of the time investor sentiment is ensconced in a normal range, where its neutral reading will provide no useful trading indicator whatsoever. This "normal range" Investors Intelligence considers to be 45% bulls, 35% bears and 20% correction.
The Sentiment Index Ranking
However, to make the index useful for traders, the company delineates a ranking system across all of its various indicators, ascribing a numerical ranking to each and every indicator, including the sentiment index. Extreme bullishness is represented by any ranking approaching -10, which indicates a potential downward change in direction of the market's direction. Extreme bearishness would be any number close to +10, which would give a signal that the market is about to change in a positive direction, with the bulls taking control.
Specific to the sentiment index, the negative rankings range from -1, which is assigned when the bulls are 51% or higher, up to -10, which is the maximum ranking, assigned when the bulls are over 60%. If the bulls fall below 45%, a +1 ranking is ascribed and if bulls fall to 36% or lower, the maximum reading of +10 is given. In the opposite direction, a -10 ranking is ascribed if the bears fall below 20%, and this ranking remains active for three months. The sentiment weighting can only ever reach a maximum -20 ranking.
Investors Intelligence also indicates "rarer event" readings. For example, if the bears go above 55% another +10 is added to the ranking for six months. In December 1994, for instance, the bulls were up to 59%+ for two weeks in a row, emitting the highest level of bullishness registered by the index in 12.5 years. Also, in February 1995, the longest bearish streak in the index's history, lasting 45 weeks, ended. The previous seven bearish "events" had been followed by average gains of 29.9% in nine months. Following this same trend exhibited by past sentiment index patterns, the Dow actually rallied by 29% by November 1995, making the February 1995 event a significant contrarian predictor. Keep in mind, however, that, even in the case of significant events indicated by the sentiment index, a matter of weeks and even months will be required for the market to move in the contrarian direction - this is obviously not an indicator that is appropriate for short-term traders!
The Bottom Line
In short, the investor sentiment is most often neutral, but it can also be slightly too bullish or bearish. By contrast, the most significant signals are given by stronger bullish or bearish rankings and by the less common occurrences of significant "event" readings. Investors Intelligence sentiment index has exhibited a high correlation with major events and the actual performance of the markets. Yet, even as the company that issues it always maintains, investors' sentiment should never be used alone, but in combination with as many other valid indicators as possible.