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Market Sentiment

12/03/02 03:48:16 PM PST
by David Penn

Take a sentimental journey through the world of contrarian investing.

One of the many golden rules for analyzing market behavior is the entreaty to not "get emotional" about the markets. Most people tend to interpret this maxim as a caution against feeling fretful or panicked during market declines. However, the truth is that the emotions of the average investor are a sword with (at least) two edges: fear as markets fall and greed as markets rise. I recall a bookstore clerk expressing mild shock at my purchase of a heavily discounted copy of The Unemotional Investor back in the boom-era 1990s. "How in the world could investing not be emotional?" she asked. But that, as they say, was then.

In fact, a number of successful traders consider themselves neither pure market technicians nor true fundamentalists. These traders spend most of their time analyzing, in the aggregate, the emotions of investors just like that bookstore clerk — and promptly betting against them. These traders are referred to as contrarians. They are practitioners of what money manager Michael Steinhardt calls the "concept of variant perception." Here's how Steinhardt describes variant perception in an interview with Jack Schwager:

I try to develop perceptions that I believe are at variance with the general market view. I will play those variant perceptions until I feel they are no longer so . . . There are certain shibboleths that exist in the world of trading, which may or may not be accurate, but I have not followed them . . . My attitude has always been that to make money in the markets, you have to be willing to get in the way of danger.

But calibrating that danger is, of course, where the devil in contrarian investing resides. Sometimes a viewpoint that is at variance with the market view is a viewpoint that is flat-out wrong, as the critics of market timers never tire of reminding us. In his autobiography, Pit Bull, market wizard Marty Schwartz speaks of Elliott wave guru Robert Prechter in a chapter titled "Sitting down by the lake, waiting for the tidal wave," highlighting Prechter's famously early call for a stock market top in the late 1980s. "Why not just ride the trend until it starts to turn down?" Schwartz recalls asking Prechter (whom, it should be said, Schwartz regards as one of the true geniuses in the field of market analysis). But to no avail. Schwartz leaves us with Prechter sitting, like Otis Redding, at the dock of the bay, waiting for a wave that was at that time still almost a decade in the future.

Does that mean that contrarian or variant perception­oriented strategies are as hopeless as their critics suggest? While Schwager exhorts those who find contrarian approaches seductive to avoid "just using sentiment survey numbers or other measures of bullish consensus," he does allow that great value exists in being "contrarian at the right time." For Steinhardt, "the right time" includes a combination of fundamental analysis and a sense of timing and risk/reward opportunities. For technically oriented traders (including, perhaps, Robert Prechter), the right time may have more to do with price action hinting a reversal is at hand. In any event, the use of contrarian investing tools such as consensus surveys and cash levels in mutual funds can be effective for full-blown contrarians as well as trend-followers eager to know when "the bend" in the trend is likely to appear.


One of the more popular contrarian indicators is the AAII (American Association of Individual Investors) sentiment ratio. The AAII is a membership organization that provides information about equity investing, mutual funds, and retirement planning for personal, retail investors. In addition to publishing a newsletter and website, AAII also publishes an informative monthly magazine, AAII Journal, that features articles on portfolio management, interviews with prominent fund managers, and tips about everything from variable annuities to taxes.

However, the AAII has been targeted by contrarian investors as something of a confidence man's "mark." The target is not the association itself, but a sentiment survey the association conducts on a weekly basis. This survey, referred to as the AAII sentiment ratio, measures the percentage of individual investors who are bullish versus the percentage who are bearish. The contrarian aspect of the survey is that when the ratio of bulls rises to a certain level, generally over 70% of those surveyed, the market is considered overbought, precariously optimistic, and ripe for a correction. Conversely, when the percentage of bulls falls beneath a certain level (generally under 30%), the market is considered oversold, unnecessarily pessimistic, and due for a rally.

Figure 1: The American Association of Individual Investors (AAII) sentiment ratio.

The AAII sentiment ratio works not just because of the truism that "the little guy is always on the wrong side of the market at major turns," but also because of the factors inherent in being bullish and bearish in the market. An equities bull is, by definition, someone who is long stocks. In other words, while an equities bull may consider adding stocks to a position, the bull already has a long position and believes that prices are headed higher. The only way prices can go higher is for other bulls to bid share prices up (or for bears and those neutral on the markets to cover their short positions and enter the market on the long side). After a certain point, when more and more bulls have piled into the market, there eventually aren't enough bulls to continue moving the stock higher.

In a sense, everyone who might be convinced the market is going higher is already in. At this moment, the market becomes especially vulnerable to setbacks and corrections, as some of those who became (or were) bullish earlier decide to take profits by selling shares to those who have arrived later.

As Figure 1 clearly shows, there are often times when sentiment suggests bearishness, for example, yet the market continues to advance. This was often the case during the market's runup from the mid-1990s to its top in 2000. This is at the heart of Schwager's warning against using sentiment numbers without understanding how to employ them properly.

To use the AAII sentiment ratio in a truly contrarian fashion, one strategy would be to look for instances of excessive optimism (over 70%) during rallies in bear markets. With such an approach, the trader or investor actually has the market on his or her side, and is essentially waiting for the fleeting mood of greed to give way to the prevailing sentiment of fear that characterized the bear market in the first place. Conversely, looking for instances of excessive pessimism (under 30%) during corrections in bull markets would be an effective way to play the temporary fear that arises from time to time within the overall context of an advancing market.


Here is a less common, perhaps less followed sentiment indicator that those who are interested in contrarian approaches may want to consider adding to their arsenal of trading tools. This indicator is based on the discount to net asset value for closed-end funds. While many are unfamiliar with closed-end funds and the nature of their premium/discount pricing, a brief review of closed-end funds and their pricing structure will show how this sentiment indicator works and how it can be used to uncover better opportunities for buying or selling equities relative to likely risks and rewards.

A closed-end fund is similar to a mutual or open-end fund in the sense that closed-end funds represent a pool of money from various investors put to work in specific investment vehicles such as stocks, bonds, and so on. Two significant differences exist between closed-end funds and mutual funds, however. First, closed-end funds have a fixed market capitalization and, as such, cannot issue or redeem additional shares (hence, they are "closed"). Second, as is pointed out in The Complete Guide To Closed-End Funds, "Since ownership interest in closed-end funds is signified by shares that are publicly traded on national exchanges . . . share price is determined independently of net asset value by factors of supply and demand."

As a consequence, closed-end funds tend to sell at a premium to their underlying or net asset value when demand is stronger than supply, and they tend to sell at a discount to their underlying value when supply is stronger than demand.

How do these premiums and discounts on closed-end funds contribute to a sentiment-based contrarian investment strategy? The thinking is that when the closed-end funds' premiums begin to grow, or when more equity-based closed-end funds start to feature premiums to net asset value as opposed to discounts, optimism about equities also grows. From a contrarian standpoint, this "good feeling" can reach levels that may be too optimistic and can be used much like an overbought/oversold indicator, warning investors and traders when markets are especially vulnerable to correction.

The same is true in the reverse. When equity closed-end funds begin to overwhelm feature discounts, the situation tends to reflect excessive pessimism on the outlook for stocks. This excessive pessimism can, at times, provide for an opportunity to buy stocks that are temporarily depressed.

Take a look at Figure 2, a chart of the closed-end fund discount to NAV based on data compiled by the Thomas J. Hertzfeld Advisors, measuring a set of 17 equity-only closed-end funds. The chart illustrates how this sentiment indicator can be read and used.

Figure 2: Closed-end fund discount to NAV indicator.

The most striking characteristic is how the indicator moved from "high pessimism—bullish" in the first quarter of 2000 to "high optimism—bearish" by the end of the year. The year 2000 was nothing like 1999, but by the end of 2000 few investors thought that the year represented much more than a temporary "basing" period from which further stock market advances were all but assured. The indicator has remained more or less in the "high optimism—bearish" range ever since, with occasional drops into the "neutral" area at the end of 2001 and again more recently with the declines of July and October 2002. But even these occasional drops never moved so far as to cause the indicator to turn bullish.


Writing about contrarian investing in his Contrary Opinion, R. Earl Hadady, the founder of Bullish Consensus, notes his "recognition of sentiment as a separate and distinct means of analyzing the markets," apart from fundamental and technical approaches, was among his most important discoveries in his years of studying the markets. This is valuable for all traders and investors to keep in mind. Using sentiment tools such as the AAII sentiment ratio, or even newer tools such as the closed-end fund discount to NAV model, can only enhance — not replace — a trader's preferred technical and fundamental methods. At a time when more and more traders and investors are recognizing the merits of combining technical and fundamental approaches to studying and trading the markets, it only seems natural that sentiment tools will increasingly find their way into the traders' toolboxes of veteran and novice traders and investors alike.

David Penn may be reached at


Cappiello, Frank, W. Douglas Dent, and Peter W. Madlem [1989]. The Complete Guide To Closed-End Funds, International Publishing Company.

Hadady, R. Earl, and Earl Hadady [2000]. Contrary Opinion: Using Sentiment To Chart The Markets, John Wiley & Sons.

Schwager, Jack D. [1989]. Market Wizards: Interviews With Top Traders, Prentice Hall Trade.

Schwartz, Martin, et al. [1998]. Pit Bull: Lessons From Wall Street's Champion Trader, HarperBusiness.

Charts courtesy of MarketGauge by DataView, LLC.

Current and past articles from Working Money, The Investors' Magazine, can be found at

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine,, and Advantage.

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