The Psychology Of Investing (Part 1)

Successful investing is about far more than understanding value, balance sheets and quality of management.  One also needs to be a pretty good amateur psychologist.  Virtually all market tops and bottoms occur at emotional extremes:  Bottoms coincide with widespread panic while Tops tend to be associated with some unjustified level of overconfidence or greed.

We continue our very bearish stance on virtually all of the capital markets.  We've given dozens of reasons that this so-called "recovery" is unsustainable and, with it, a major, major peak is being formed in the capital markets. 

In addition to all the reasons for concern previously discussed, another subset of technical analysis referred to as "sentiment" analysis is clear in its verdict:  SELL!

The theory behind sentiment analysis is quite simple, and so logical that Mr. Spock himself would not even raise an eyebrow.  Market peaks occur when buying power has become exhausted.  This happens because those buyers have become either complacent, overconfident or just plain greedy.  Once they've all bought in, who's left to buy?

This level of emotional extreme can be measured quantitatively, so one need not be an empath to get a good fix on things.  The most basic form of sentiment reading is the market poll.  There are several which have long track records, are consistently applied and easily accessible for historical analysis.  The two of note are Investor's Intelligence which polls newsletter writers and the American Association of Individual Investors (AAII) which polls retail investors.  Barron's reprints a number of these polls every week http://online.barrons.com/public/page/9_0210-investorsentimentreadings.html.

The AAII poll currently shows 49.7% bulls versus 26.2% bears.  These numbers are at major, major top historical readings and suggest any further upside from here can not be ruled out, but must be viewed as quite limited.  Investor's Intelligence confirms similar results.  The most recent readings are consistent with levels virtually identical to the tops reached in 2007 and 2000, with 55.4% Bulls and 21.8% Bears.

Other sentiment indicators are less precise but, nonetheless meaningful.  Just two days ago, Goldman Sachs issued its 12 month projection of 1,450 on the Standard & Poors 500 (SPX) or a gain of 25% from here.  This forecast was not directly attributed to "Dear" Abby Joseph Cohen, but suffice it to say that Ms. Cohen is a notorious perma-bull who never met a reason not to recommend stocks even at extremes of overvaluation.  She was quite bullish at the upper end of the Nasdaq bubble, issuing bullish forecast after bullish forecast.  Somehow, she kept her job.

There is the "Magazine Cover" indicator.  Mainstream publications like Business Week, Time and Newsweek are famous for having cover stories about the "Death Of Equities" or the "New Age of Investing" almost exactly at market peaks and bottoms.  These publications act as investor polls in and of themselves, merely reflecting what their readers believe.

Another excellent sentiment reading, and probably the best one of all, is the level of market volatility.  This one may be best because it's determined through actual trading.  Volatility is a statistical measure of the expected degree of variability in stock prices over various subsets of time.  It is a key component in options pricing, but very, very useful in understanding exactly where investors sentiments lie.

There are several measure of volatility, but the best one is called the VIX, which is its symbol.  At market bottoms, the VIX will have readings of above 50.  Literally translated, this means that investors have priced in a range of up or down 50% over the coming year.  At the other end, VIX can print under 10%, indicating complete complacency or lack of fear.  A 3 year chart of VIX can be accessed by clicking here:  http://bigcharts.marketwatch.com/quickchart/quickchart.asp?symb=vix&sid=0&o_symb=vix&freq=2&time=10.

You will note that VIX is currently incredibly low and confirms the very ominous readings mentioned above in the investor sentiment polls.

Think this is all there is to sentiment?  Not even close!  In Part 2 we'll discuss other very interesting indicators of how investors deploy capital and how it gives us pundits a means of understanding what's in their heads.

All in all, this is still a time to remain very, very cautious and keep levels of cash high. 

Marko's Take