The Psychology Of Investing (Part 2)

As described in Part 1 http://markostake.blogspot.com/2010/12/psychology-of-investing-part-1.html, successful investing is far more than understanding finance and business.  If it were that easy, every MBA would be rich.  In fact, even experienced professional investors endure breath-taking losses.  Many, many hedge fund managers have lost every single penny under management in days because they made very basic mistakes.

Making money requires some degree of timing.  While investment legends such as Warren Buffett and Benjamin Graham completely avoid market timing, they would not disagree that there are far better times to enter a position and exit a position than others.

Entering a new position when there is panic is a far better bet than when shoe-shine boys and taxicab drivers are giving stock tips.  So, we turn again to different ways to measure investment sentiment.

Statistics from a mutual fund group called Rydex provides an interesting way to gauge how investors are thinking.  Rydex has been a pioneer in the creation of inverse funds, that is, funds which produce returns when markets go down.  Technicians have created "Rydex Ratios" which measure the employment of assets in long-biased funds versus those in the inverse or "short" funds.  In general, the more assets are playing the short side, the more bearish investors are, and the more likely that a bottom is at hand.

A practioner of the Rydex Ratio is Shaeffer's Investment Research  http://www.schaeffersresearch.com/.  A recent graph of the Rydex Ratio using asset investment in long versus short Standard & Poor's 500 index funds can be accessed by clicking here: http://www.schaeffersresearch.com/streetools/market_tools/rydex_nu.aspx.

Another set of indicators employs options buying and selling statistics.  Put options buyers bet on falling prices while call option buyers bet on rising prices.  Therefore the "put/call ratio" tracks bearish versus bullish bets and acts as a contrary indicator.  These ratios can also be found in Shaeffer's Investment Research by clicking here:  http://www.schaeffersresearch.com/streetools/market_tools/cboe_eqpcr.aspx.

Probably the most comprehensive sentiment analyst is a guy named Jason Goepfert who has a newsletter known as Sentiment Trader http://sentimenttrader.com/.  I have been a subscriber to this newsletter and it has been quite valuable as a resource.  A little more information on Jason can be accessed here:  http://wallstcheatsheet.com/knowledge/interview-knowledge/exclusive-sentiment-trader-founder-jason-goepfert-shares-3-keys-to-success.html.

Jason creates a very comprehensive measure of sentiment using a variety of indicators, of which some are the result of his proprietary research.  His short-term position, as of December 10th, 2010:  "We've been looking for a 2-3 day decline, but stocks aren't accommodating. We'll move back to Neutral if SPY trades above 124.16. If that happens in the first 1/2 hour of regular trading on Friday, then SPY drops back under 123.60, we'll move back to 25% Bearish."  Goepfert's intermediate-term position is neutral.

Jason constucts several models of investor emotion.  His composite index is constructed using the following indicators:  Sentiment surveys, proprietary versions of the positioning of Futures traders, puts/calls, volatility indices, breadth ratios, the "Trading Index" or TRIN, and several un-published indicators. 

He also measure the positioning of "smart" to "dumb" money, or those folks who have a tendency to be consistently right versus those consistently wrong.  One example of "smart money" would be corporate insiders who are in the best position of knowing how their companies are doing.  When corporate insiders buy their own stock, that is about a good of an endorsement of a company's prospects as you can get.  Dumb money is your typical retail investor and option speculator, who tend to be wrong far more often than right.  Currently, according to his research, smart money is 33% confident in a rally, while dumb money is 79% confident.  Fortunately, Marko's Take would agree wholeheartedly with the smart folks.

Taking everything together, virtually any reasonably calculated sentiment measure is suggesting that market confidence is at unsustainable levels.  Most measures are within striking distance or exceeding the type of euphoria which characterized the major tops in 2000 and 2007. 

As for the Gold market, analyst Mark Hulbert measures sentiment in the precious metals arena.  As of November 24, Hulbert's conclusion is that sentiment remains FAR from overheated.  His most recent publicly available views are described here:  http://www.marketwatch.com/story/contrarian-analysis-of-the-gold-market-2010-11-24.

We remain a bit cautious on Gold near-term, but expect any correction to be sharp and short-lived.  It would be preferable for the precious metals complex to get a bit of a shake-out, but these types of parabolic moves often leave investors waiting for corrections which never come.

Marko's Take