Investors and traders spend an enormous amount of time trying to figure out what markets will do next. There is no shortage of indicators telling us what investors are thinking, what they are buying and what they are expecting. This came up in a call with some partners this morning and it reminded me why I continue to pay attention to sentiment indicators although probably not for the reason most people do.
Well, the theory of contrary opinion is fairly simple. When “too many” investors become bullish, a large part of the potential buying may have already taken place. There are fewer buyers left to push prices higher, so the market can become vulnerable to a relatively small piece of bad news.
The reverse is also true. When “too many” investors become bearish, much of the potential selling may already have happened. There are fewer sellers left, and it may not take much positive news to send prices higher.
This is why I’m more interested in extremes than simply knowing whether investors are bullish or bearish. If everyone is standing on the same side of the boat, I would at least like to know how big the boat is.
One of the topics we discussed this morning was how I use a number of these indicators to complement my investment work. Sentiment is only one part of the process.
We also look at positioning, valuations, market behaviour and other variables. I do not believe any single indicator can tell you where a market is going, if only investing were that easy.
The objective is not to predict the future. It is to understand when expectations have become so one-sided that the balance between risk and reward may be starting to change.