Does investor sentiment predict market rallies?

Read any discussion about stockmarkets particularly when they're falling and the chances are it won't be long before the word "sentiment" crops up. For example, last week, one Financial Times writer blamed "bearish sentiment" for investors withdrawing $12.4bn from equity funds. Of course, with hindsight it's easy to blame market swings on mood swings. But can you use investors' moods to judge what will happen next?

Investors who consider themselves contrarians tend to pay lots of attention to sentiment. Markets are driven by human beings, who are prone to overenthusiasm when markets go up, and pessimism when they're going down. As a result, markets or individual stocks are often over- or undervalued, which can spell opportunity for the level-headed. As the father of value investing, Benjamin Graham, put it: "in the short run, the market is a voting machine, but in the long run, it is a weighing machine". So if you can work out when the market is being irrational, you can make money by taking the opposite side of the trade.

A popular way to measure sentiment is to look at what the press is saying. The "magazine cover" indicator, and its derivatives, suggest that if market news is making headlines, then a trend is probably near its end. Famous examples include the BusinessWeek "Death of Equities" cover that appeared in 1979, not long before the start of a multi-year bull market. But while such indicators make great anecdotes, they're hardly scientific.

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Is there a more precise measure? One way to gain greater accuracy is to poll investors on their short-term expectations. One of the best known of such polls is by the American Association of Individual Investors' (AAII), which has surveyed its members (wealthy individual investors) every week since 1987. In a 2013 study, Charles Rotblut claimed there was evidence for the survey being a contrarian indicator: "extraordinarily low levels of optimism have consistently preceded larger-than-average six- and 12-month gains in the S&P 500". That could be a good sign for markets right now45.5% of investors are bearish, and just 17.9% bullish.

Another idea is to look at where investors are putting their money, using the put/call ratio. "Puts" are options that enable the holder to sell an asset at a certain price; "calls" allow the holder to buy. So buyers of puts profit if the market falls; buyers of calls profit if it rises. If more puts are being sold than calls (a high put/call ratio) it indicates bearishness. This worked well for contrarians during the tech bubble the ratio on the S&P 500 fell as low as 0.45 before the peak, indicating bullishness and a good chance to sell. Right now, according to the Chicago Board Options Exchange, the volume of puts being traded is greater than the number of calls for the index and shares in general, again a bullish contrarian sign.

These indicators might work on occasion, but none is foolproof. Rather than time the market, which is what this is, a better bet is to use any slump to buy what's cheap, then be patient. Buying cheap stocks works in the long run (value investing is one of the few factors flagged up as a market-beating strategy in most studies). If you can accept that cheap stocks often get cheaper before the turnaround, it's a better way to invest than hoping to pick the point at which investor sentiment becomes most extreme.

Where the herd is stampeding to now

Once a month, Bank of America Merrill Lynch (BoAML) puts together a survey of global fund managers, canvassing their views on global markets and finding out where they are putting their money right now. Given that professional fund managers have a tendency to herd in just the same way as the average investor in the street, the survey can be worth looking at to get a sense of what's popular and what's not so hot (and therefore of potential interest to contrarians).

Interestingly, despite the recent turmoil, investors are not yet "max bearish", says BoAML. Only 12% believe that a recession will happen in the next 12 months and most remain happy to favour equities over bonds (hardly a defensive stance). However, cash positions are heading higher the average fund manager is holding 5.4% of their money in cash, which may not sound a lot, but is in fact the third-highest reading since 2009. Another point worth noting is that the near-universal bullishness on the US dollar has unwound somewhat, with investors starting to believe that the Fed won't be able to hike interest rates as aggressively as it had previously expected.

So the professionals are gloomy, but could get much gloomier yet. BoAML still reckons we should "sell bounces until the 4Cs (China, Commodities, Consumer, Credit) improve". That said, what's probably the most interesting part of the survey from a contrarian investor's point of view is that fund managers have never been as underweight the global materials sector (in other words, they don't own resources companies, or if they have to, they own a lot fewer of them than compared to the long-term average). Indeed, they're even more aggressively bearish than in 2008. So while a bounce back might not be on the cards yet, it wouldn't take much of an improvement in the economic backdrop to spark some buying interest in the sector. That's something to watch closely.