Mostly: Classical

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Dour Crowd So Wrong It's Right; Market Has Rallied For 6 Week

BY KEN HOOVER

INVESTOR'S BUSINESS DAILY

Posted 11/25/2005

"When everyone thinks alike, everyone is likely to be wrong," legendary stock market sage Humphrey Neill said decades ago.

It's a timeless paradox: When the crowd is certain stocks can only go lower, the market goes higher. And when everyone is giddy with optimism, the market is likely ready to take a costly tumble.

Investors should focus their attention on the price and volume action of the major market averages and leading stocks.

The market bottomed on Oct. 13, then followed through with a strong gain on good volume Oct. 19. It signaled further strength on Nov. 2 and 3.

Still, sentiment indicators do help provide a fuller picture of how the market is doing.

So what is the mood of investors now that a solid-looking rally is more than one month old?

Earlier this month, an indicator created by market strategists at Citigroup signaled one of the highest levels of pessimism since 1994, when the market was about to start a powerful bull market. Investor gloom is even deeper than after 9-11 or just prior to the Iraq War in March 2003.

"On of the reasons is that even though 9-11 was a huge shock to everyone, in many instances people just hung on. It was too late to sell," said Citigroup strategist Tobias Levkovich.

The indicator is called the Panic/Euphoria Model or the Other PE.

Each year, Levkovich and his colleagues sort through 60 indicators of market sentiment. They pick the eight with the best predictive records over the past 18 years and mold them into the Panic/Euphoria Model.

By doing this, Citigroup aims to address a common shortcoming with psychological indicators: A particular gauge may spot market tops or bottoms for a while, then stop working.

The model's current sentiment indicators are:

• Margin debt.
• Nasdaq volume as a percentage of NYSE volume.
• Retail money flows
• Put/call ratio.
• CRB futures index.
• Gasoline prices.
• Short interest ratio between public and NYSE member firms.
• The average between the Investors Intelligence and American Association of Individual Investors.

"It's dangerous to rely on just one factor," Levkovich said.

The weekly composite indicator hit a low of -0.87 on May 6, just as the market was starting a rally that would last until August. It bottomed again at -0.83 on Nov. 4, right after the market moved decisively higher, reconfirming the current rally.

The lowest reading ever was -0.88 on July 15, 1994, just before the start of a huge bull market.

Levkovich won't give away many details of how the indicator is constructed except to say that five of the eight components are contributing to the buy signal.

It's not hard to identify some of them.

Key Bullish Levels Triggered

The put/call ratio hit 1.07 on Oct. 12 and 13, just as the market was hitting bottom. Readings over 1.0 occur when investors are buying more bearish puts than bullish call options, which tends to happen near intermediate market bottoms. It hit 1.18 on Oct. 14, 2004, just as a year-end rally was getting under way, and 1.22 this year on April 15, days before the start of a rally.

Nasdaq volume has also been moderate as a percentage of NYSE volume. When investors feel confident, they're more likely to trade in speculative Nasdaq names. When they're scared, they tend to stick with stable NYSE stocks.

The CRB futures index, a measure of the prices of a basket of commodities, and gasoline prices don't seem like psychological indicators at first glance. But Levkovich insists they are.

"When people are buying high prices at the pump, they feel kind of lousy," he said.

And rising commodity prices are a sign of a recovering economy, he added.

One perplexing sentiment indicator is the Investors Intelligence weekly poll of investment advisers. A staple of market watchers since 1963, the poll hasn't signaled a prolonged period of bearishness among newsletter writers since 1994. There hasn't been more bears than bulls since October 2002.

John Gray, Investors Intelligence editor, said he now considers a bullish reading when the spread between bulls and bears gets down to 12 or 15 percentage points. He says there's too many bulls when the number gets to 55% or 60%.

Its last low was Oct. 28, when there were 44.8% bulls and 29.2% bears. The current reading is 53.1% bulls and 29.1% bears.

Some popular sentiment indicators are absent from Levkovich's model, including the closely watched CBOE volatility index, known as the VIX. He says it's lost its predictive power because of professional hedging strategies and the increased use of exchange-traded funds, or ETFs, which decrease volatility.

Confirming Citigroup, another sentiment gauge, the State Street Investor Confidence Index, gave its lowest reading in October going back to 1998. The index has rebounded this month.

The State Street index seeks to track the movement of institutional money into and out of stocks. It shows that institutions are as subject to crowd psychology as anybody else.

The index's lowest reading until now was October 1998 when Russia defaulted on its debt and a big hedge fund collapsed, threatening some banks. But it was the exact right time to be ready to put money into the market.

But not everybody's sentiment index is flashing a big buy signal.

Tim Hayes maintains his own composite index for Ned Davis Research and it shows a moderate amount of optimism. It's a more short-term indicator that moved quickly from showing modest pessimism. It's given six buy and six sell signals since the end of 2003.

URL: http://investors.com/editorial/IBDArticles.asp?artsec=16&issue=20051125


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