Using Sentiment Indicators for Market Timing

While many market participants are constantly looking at charts trying to decipher what the zigs and zags mean, they are forgetting about a powerful indicator called investor sentiment. Quite simply, a sentiment indicator measures what market participants are thinking and feeling. The line of reason behind this method is that the herd is usually bearish at the bottom and bullish at the top and make for a great contrarian indicator. I have noticed that over the last 1-2 years sentiment indicators have been more accurate when it comes to market timing than normal technical indicators. Remember March of 2009 when everyone was bearish and retail investors were busy pulling tens of billions out of the market? That of course was the exact opposite of what they should have been doing as the market bottomed and surged 80% in 14 months. In the stock market emotions (fear and greed) are not your friend. You have to have the understand that it is most profitable to buy fear and sell greed in the market and sentiment indicators are the only way to achieve this.

There are many sentiment indicators out there and none of them are 100% accurate. I have found that it is best to follow 5-10 indicators and only make a trade when the majority of them are at a buy/sell level. Here are a few that I follow:

A proprietary indicator developed by Market Harmonics to measure bullish and bearish sentiment trends and potential reversals in the NASDAQ and tech-related
2. Put/Call Ratio---
Daily Put/Call ratio data based on total CBOE options volume.
3. Volatility Index (VIX)---
Vix is generally considered the fear gauge in the market and always spikes higher when the markets are declining and people are panicking. Short term bottoms are usually close when the vix gets between 30-40.
4. Investors Intelligence Survey---
Charts created from weekly data courtesy of Investors Intelligence. The data is used to determine the ratio of bulls to bears to signal potential sentiment extremes that lead to market reversals. Not as reliable as the other indicators but is useful when the indicator is at an extreme.  
5. ISEE Sentiment Indicator-
Is an indicator that uses the number of calls and puts purchased by customers on the International Stock Exchange and does not include market makers. Generally a number above 225 means the market is bullish and is likely near a top. Conversely a number near 100 means the market is negative and the market is near a short term bottom. I only use the 10 day moving average.
Lets take a look at one of my favorite indicators (NASDAQ Sentiment Indicator) and see if it was helpful to investors.
If you look carefully you will notice that towards the end of April the index hit an extreme high indicating a high degree of investor sentiment. This turned out to be a good warning to contrarians to be selling long positions and initiating short positions. You will also see that the index fell quite sharply during May's steep decline in stocks and fell to a low that had not been seen since Oct/Nov 2008(market crash). Despite the doom and gloom in the press and blogosphere this was the time to be buying and since then the market has rallied nicely.   

So far I have discussed the benefits of these indicators but I also need to note the disadvantages. Based on my personal experience these indicators are correct within about 3-10 trading days. While this may sound pretty good it is very hard to be buying stocks when the markets are in free fall. You feel like you are walking into a buzz saw so you have to be willing to hold your position knowing that you will never perfectly time the market. To do this I suggest buying in increments and only averaging up for long positions and averaging down for short positions. 

In conclusion sentiment indicators should be an integral part of an investors tool kit to help them make investing decisions. It allows you to take control of market fluctuations rather than being a victim who sells in panic at market bottoms and buys at market tops. I can say from personal experience that following sentiment has helped me stay on the right side of the market. My own sentiment regarding market fluctuations has changed dramatically in the sense that I am only bullish when there is extreme market bearishness and visa versa.  

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