With last week ranking as the worst for the S&P 500 since 2012, the bears are out in full force.
By some measures, market sentiment has not been this negative since August 2011.
Market sentiment occupies a curious position in investing.
In many ways, it is the red-headed stepchild of stock market investing.
In a world awash and bedazzled by complex financial models, gauging market sentiment doesn't seem as legitimate, as, say, fundamental or even technical analysis.
After all, the best investors in the world know that the short-term price of financial assets is driven by little else.
Warren Buffett was a disciple of Ben Graham and a value investor. That places Buffett firmly in the fundamental analysis camp.
Yet, Buffett has said that the single-most-important thing he has ever read was Graham's chapter on Mr. Market's Moodswings in "The Intelligent Investor."
And “Mr. Market” is just another metaphor for market sentiment.
In his book, Graham compares the market to a manic-depressive.
Some days, Mr. Market is euphoric. On other days, he's very depressed. If you catch him on a euphoric day, he wants a very high price for his shares. If he's in one of his down moods, he's willing to sell you his shares for a pittance.
Mr. Market highlights the one thing you can predict with certainty about financial markets: investors will always overreact to events -- whether positive or negative.
And it also highlights how savvy traders profit from just such overreactions.
Why Market Sentiment Matters
So why is an understanding of market sentiment so crucial?
It is because it gives you an edge.
Both mainstream fundamental and technical analysis are pretty much commonplace.
Every financial analyst in the world studies from the same textbooks.
With all financial analysts trained the same way, it’s hard to generate the kind of novel perspective to distinguish yourself from the crowd.
You can say the same about technical analysts.
How To Make Money From Market Sentiment
One myth surrounding market sentiment is that it is not quantifiable.
Nothing could be further from the truth.
CNN tracks seven time-honored sentiment indicators in its “fear and greed” index.
This index tracks seven time-tested market sentiment indicators, including market volatility, market momentum, market breadth and put call ratio, among others.
I look at this index daily to gauge the mood of the market.
And truth be told, I find it a heckuva lot more useful than looking at fundamental measures like price-to-earnings (P/E) or earnings growth.
One of my favorite websites, sentimenTrader.com, also does a terrific job of coming up with dozens of customized sentiment indicators.
Of course, you can quibble about the accuracy of each individual indicator.
But taken together, they give you a terrific sense of the mood of the market.
I also use measures of market sentiment in making recommendations in my trading services, Bull Market Alert and Triple Digit Trader.
This focus on market sentiment prompted me to recommend placing profitable bets on the Russian stock market the day after it annexed Crimea.
It also allowed me to recommend a bet on a bounce in the Gulf State’s stock markets when those markets fell out of bed a few weeks ago.
How to Profit From Today’s Market
So what’s the verdict of market sentiment on the current market?
With the market in “extreme fear” mode, today’s market sentiment has not been this lousy since January.
And markets tend to bounce strongly when investor sentiment reaches negative extremes.
That alone means: “buy, buy, buy.”
Here’s a caveat, though.
Looked at from a historical perspective, the market’s current pessimism seems way overdone.
Today’s investors have been spoiled by the market's incredibly narrow trading range and low volatility.
After all, the S&P 500 is only 2.3% off of its highs.
And we are a long, long way from the much-feared 20% correction the market endured in August 2011.
Recall that was the month the Standard & Poor’s downgraded U.S. government debt from its longtime “AAA” rating.
Meanwhile, Warren Buffett was buying stocks hand over fist on Aug. 8, and I called that pullback the “buying opportunity of the year.”
Here is some more evidence that the current pullback isn’t the “big one.”
According to sentimenTrader.com, when you see downside shocks in the S&P 500 like we did last week, historically, it has been more of a sign of a temporary dislocation than a coming implosion of financial markets.
After an additional shorter-term downside, stocks normally resume their upward trend within a few months. Specifically, it took a median of five weeks and a maximum decline of 1.4% before the S&P closed at a new 52-week high.
The bottom line?
The market is likely to be choppy over the next couple of weeks.
But if you play the odds, you should bet that the market will recover.
And I expect that the few brave investors who were willing to bet against market sentiment will be once again sitting on big profits.
In case you missed it, I encourage you to read my e-letter column from last week about why you should pay attention to global currencies. I also invite you to comment in the space provided below my Eagle Daily Investor commentary.
Nicholas Vardy, CFA
Editor, The Global Guru
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