How to measure investor sentiment

Investor sentiment is a vital indicator - it can signal a turning point in the markets. And having the knowledge to turn before the tide can pay dividends. Here, Tim Bennett gives three tips for gauging the mood of investors.

Investors act in herds. There is a perceived safety in large numbers. So when everyone was buying technology stocks in the late 1990s, anyone left out was tempted to pile in too after all, could so many other people really be wrong? It works the other way too. After Lehman Brothers collapsed in 2008, many investors, who had held their stocks through all the uncertainty up until then, watched markets plunge and dumped their stocks in a panic.

In short, we are all driven as much by greed and fear as we are by any rational assessment of when we should buy and sell. That's why sentiment is a vital investment indicator. When investors are too gloomy or too cheerful, it often signals a turning point in the markets. But how do you measure investor sentiment?

Charles MacKinnon and David Livingstone of Thurleigh Asset Management believe they have found three indicators that can reveal when investors have become too euphoric.

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Working with Said Business School, they have looked at 50 years' worth of data and around 20 different sentiment predictors. These range from flows into mutual funds (large flows suggest bullishness) to the first day performance of new listings (a big uptick suggests investors are confident) to the American Association of Individual Investors survey, which questions retail investors about their expectations for the market. They then looked at how these indicators behaved just ahead of a series of huge stockmarket corrections or even crashes, such as the dotcom bust. They were looking for indicators that were not just reliable, but also independent of one another (so one did not blindly follow another). Here are the three they chose:

1. S&P 500 put/call ratio

Put options are used mainly by professional investors as insurance to protect a portfolio against a potential stockmarket fall (usually within the next three to nine months). Call options are used to hedge (or bet on) a rise. To get the ratio, you divide the volume of S&P 500 puts by the volume of calls. A ratio above one suggests that, on balance, investors are bearish; below one, they're bullish.

Before the recent crash it stood at 0.87 (indicating slightly fewer puts than calls). This was a "bullish continuation" pattern, notes, but not the headless rush of enthusiasm (a much lower ratio) that points contrarians to an imminent crash. However, since the markets plunged following the news on Japan, it has jumped to a more bearish (though not extreme) level of 1.18.

2. Gold/silver ratio

This ratio expresses the price of one ounce of gold as a multiple of one ounce of silver. So with the gold price at around $1,400 and the silver price at $35, the ratio is around 40. In terms of recent history, that's quite extreme, as Dominic Frisby notes in Money Morning: "the 40-45 area has been a key pivotal point" in the past. So what does it show?

Gold is a classic 'safe haven' asset with few uses other than as a precious metal. Silver is a precious metal too, but it also has several industrial uses and trades in a much smaller market. So if the gold/silver ratio starts falling sharply it suggests that either the gold price has collapsed (which it hasn't) or that silver has surged (which it has, to trade at 30-year highs).

Given that silver is seen as the poor relation to gold in 'safe haven' terms, the recent surge suggested that investors were bullish about future industrial demand and therefore stock prices.

But since the earthquake, while gold and silver have both fallen, silver's decline has been more rapid, so the gold/silver ratio has risen, suggesting investors are less bullish.

3. Corporate bond/Treasury spread

This indicator looks at the gap between the yield on safe seven-year US Treasury bonds and the higher yield on much riskier Baa-rated US corporate bonds. If this starts to narrow, it suggests that bond investors are feeling bullish, and expect firms to do well, and so are willing to take the higher risk of holding corporate bonds rather than Treasuries. Again, for a contrarian this is a 'sell' signal. Since the end of last year the gap has narrowed to around 2.6% (it was nearer 3.3% in November 2010). That's partly down to US Treasury yields rising rather than Baa yields falling. But since the quake hit, the spread has widened slightly, to 2.65%.

So, what does this all mean? Before the crash, the Thurleigh/Livingstone index, which combines all three indicators into a single score, was mildly negative, suggesting possible trouble ahead. Clearly, such indicators can't forecast natural disasters, but they can suggest when the market is likely to be more vulnerable to shocks, such as the Japanese earthquake, or the turmoil in the Middle East.

If the situation in Japan turns out to be less serious than markets fear, there's a chance there could be a rapid re-bound as investors decide they should be 'buying the dips'. We'd be cautious: with sentiment still far from bearish, any such rally could end up being short-lived.

This article was originally published in MoneyWeek magazine issue number 529 on 18 March 2011, and was available exclusively to magazine subscribers.

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Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.