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Sentiment Indicators

Investors/traders track a range of sentiments (consumer, investor, analyst, forecaster, management), searching for indications of the next swing of the psychological pendulum that paces financial markets. Usually, they view sentiment as a contrarian indicator for market turns (bad means good — it’s darkest before the dawn). These blog entries relate to relationships between human sentiment and the stock market.

Using Commitments of Traders Reports to Time Asset Allocations

Is the aggregate sentiment of futures traders predictive for asset returns? In the June 2008 update of their paper entitled “How to Time the Commodity Market”, Devraj Basu, Roel Oomen and Alexander Stremme investigate whether information in the weekly Commodity Futures Trading Commission’s Commitments of Traders (COT) reports enable successful timing of U.S. equities and commodities markets. These reports aggregate the size and direction of the positions taken by different categories of futures traders in different assets. “Commercial” traders use futures contracts for hedging, “non-commercial” traders use them for other types of speculation and “non-reportable” traders operate below the reporting threshold. The study seeks to exploit “hedging pressure” (the fraction of positions that are long) for each of six liquid commodities (crude oil, gold, silver, copper, soybeans and sugar) and for the S&P 500 Index. Each Friday, the six trading strategies studied: (1) take a long position in a commodity if hedging pressure for both the commodity and the S&P 500 Index are below their 52-week averages; or, (2) take a long position in the S&P 500 Index if hedging pressure for both the commodity and the S&P 500 Index are above their 52-week averages; or, (3) hold 3-month U.S. Treasury bills. Using COT reports and associated weekly futures prices for October 1992 through December 2006, they conclude that: Keep Reading

Extracting the Irrational Part of VIX

Does the Chicago Board Options Exchange Volatility Index (VIX) have separable components of rational and irrational risk? If so, is the irrational risk component of use to investors? In their October 2009 paper entitled “Risk Sentiment Index (RSI) and Market Anomalies”, Guy Kaplanski and Haim Levy introduce the Risk Sentiment Index (RSI) as a measure of the residual risk contained in VIX after accounting for the statistical and economic variables most predictive of future stock market volatility (such as previous month actual volatility and VIX). They also analyze factors which affect RSI and its relationships with day-of-the-week and month-of-the-year stock market anomalies. Using daily closes for VIX and the S&P 500 Index during 1990-2007 (4,538 days) and for the Volatility Index Japan (VXJ) and the Nikkei 225 Index during 1995-2007 (3,200 days), they conclude that: Keep Reading

Short-term Net Money Flow and Stock Returns

A reader asked: “Is there any tradable relationship between aggregate net money flows and market returns. I have read many articles pointing out how, according to money flows, investors got out at the bottom in 2008. Can flows into the equity market at large predict (or ‘inversely’ predict) returns?” To check, we relate return to the net money flow reported in the referenced Wall Street Journal data, focusing on the Dow Jones Industrial Average (DJIA). Using DJIA net money flows and DJIA returns at weekly and monthly intervals since May 2007 (the earliest available), we find that: Keep Reading

Aggregate Money Flow a Useful Stock Market Indicator?

A reader noted and asked: “Please look at the chart in “How Investors Lost Money: Evidence from Mutual Fund Flows”. Can money flows into the equity market at large predict (or ‘inversely’ predict) returns?” Keep Reading

Purifying Stock Market Sentiment Indicators

It is arguable that sentiment indicators derive substantially from what just happened in the stock market and that they therefore add little or no value to price action itself in predicting future returns. In their May 2009 paper entitled “Purified Sentiment Indicators for the Stock Market”, David Aronson and John Wolberg investigate this thesis by removing the influence of recent stock market price dynamics (defined by 18 variations of price velocity, acceleration and volatility) to produce multiple “purified” versions of each of five sentiment indicators: (1) the CBOE Implied Volatility Index (VIX); (2), the CBOE Equity Put-to-Call Ratio (PCR); (3) the American Association of Individual Investors Bulls minus Bears (AAII); (4) the Investors Intelligence Bulls minus and Bears (INV); and, (5) Hulbert’s Stock Newsletter Sentiment Index (HUL). They then measure the power of the purified sentiment indicators to generate profitable trading signals by testing 100 signaling rules for each indicator. Using data for the five sentiment indicators from initial availability (ranging from January 1963 to July 1987) through October 2008, along with contemporaneous daily closes of the S&P 500 index, they conclude that: Keep Reading

Google Search Data as a Measure of Investor Attention

Do new technologies offer more powerful and immediate ways to measure investor sentiment? In the March 2009 version of their paper entitled “In Search of Attention”, Zhi Da, Joseph Engelberg and Pengjie Gao investigate the link between investor attention and asset pricing dynamics based on the levels of and changes in the Google Search Volume Index. Using weekly search frequency data for Russell 3000 and Initial Public Offering (IPO) stock ticker symbols over the period January 2004 through June 2008, along with contemporaneous trading, firm characteristics and news data, they conclude that: Keep Reading

Comparing German and American Investor Sentiment Indicators

Does investor sentiment predict future stock returns, and does the release of new investor sentiment data therefore cause an immediate market reaction? In the February 2009 version of their paper entitled “Not so Dumb Money: The Prognostic Power of Investor Sentiment over Time”, Jördis Hengelbrock, Erik Theissen and Christian Westheide measure the predictive power of German and U.S. investor sentiment indicators and test whether the market responds immediately to the release of new sentiment data. For the German market, they define investor sentiment using the Sentix value index (percent bullish minus percent bearish), derived from a weekly survey of institutional and individual investors regarding their outlook for German equities over the next six months and published on weekends. For the U.S. market, they define investor sentiment using an American Association of Individual Investors (AAII) value index (percent bullish minus percent bearish), derived from a weekly survey of individual investors regarding their outlook for U.S. equities over the next six months and published before the market open on Thursdays. Using AAII survey results for July 1987 to June 2008 and Sentix survey results for February 2001 to June 2008, along with contemporaneous stock index levels, they conclude that: Keep Reading

De-Snooping Market Timing Rules Based on Fundamental and Sentiment Indicators

Some analysts fail to account for data snooping bias in their analyses of market timing indicators. This bias amounts to incorporating pure luck into results by testing many different rule variations or parameter settings within rules (or inhaling the “secondary smoke” of other analysts who have already screened a set of rules/parameters). This luck does not persist out-of-sample. Do any market timing rules generate outperformance after correcting for this bias? In their February 2009 paper entitled “Data Snooping and Market-Timing Rule Performance”, Andreas Neuhierl and Bernd Schlusche assess the profitability of a comprehensive set of simple and complex market timing rules based on fundamental indicators and investor sentiment indicators after correcting for data snooping bias. Simple rules derive from a single indicator, and complex rules derive from multiple indicators. Using thousands of simple and complex rules based on data for the S&P 500 to time the daily close of the S&P 500 index over the period 1980-2007, they conclude that: Keep Reading

Do Stock Index Put-Call Ratio Trend Reversals Anticipate Trend Reversals of the Index Itself?

A reader inquired: “In some technical analysis papers I read that trend reversals of the 10-day [lagging] average put-call ratio anticipate S&P 500 index trend reversals. Do you see any predictive power?” In other words, does a change in the trend on an index put-call ratio (P/C) predict a general shift in investor sentiment? This question is fairly complicated from an analysis perspective, requiring definitions of “trend,” “trend reversal” and “anticipate.” We define “trend” as the normalized slope for the last ten trading days for both the S&P 500 index and the ten-day lagging average index P/C over the past ten trading days, normalizing by dividing the raw slope by the average value over the same ten trading days. We define “trend reversal” as a point at which the normalized slope crosses zero either from above or below (slope changes from positive to negative or negative to positive). We define “anticipate” as evidence of a systematic relationship between points at which the normalized slope of the ten-day average P/C changes sign and points at which the normalized slope of the S&P 500 index changes sign in the same direction. Using daily P/C data for the S&P 500 index from CBOE for the period 10/17/03 through 1/9/08 (1,317 trading days) and contemporaneous daily closing levels of the S&P 500 index, we find that: Keep Reading

Investor Sentiment and Returns for Different Types of Stocks

For what types of stocks is sentiment trading most likely to work? In the June 2008 update of their paper entitled “How Does Investor Sentiment Affect the Cross-Section of Stock Returns?”, Malcolm Baker, Johnathan Wang and Jeffrey Wurgler investigate returns for different types of stocks in the context of broad investor sentiment index derived from principal component analysis of six indicators: trading volume as measured by NYSE turnover; the dividend premium; the closed-end fund discount; the number of, and first-day returns on, Initial Public Offerings; and the equity share in new issues. Using this sentiment index and monthly stock return and characteristics data for 1962-2005, they conclude that: Keep Reading

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