Ned Davis Research (NDR) is a well respected advisory firm, known for its careful and at the same time imaginative data analysis. In The Triumph of Contrarian Investing (McGraw-Hill, 2004) Ned Davis argues that if market action is largely a result of mass psychology, as he believes, it makes sense to incorporate quantitative indicators of crowd psychology in market timing models.
For the trader who wants to catch major market turning points “wait for majority opinion to reach an extreme and then assume the opposite position. At turning points, contrary sentiment indicators are nearly always right.” (p. 9) The reason is simple; everyone who wants to buy a rising market, for instance, has already done so, there are no buyers left to drive prices higher.
And, as a corollary, with all the talk recently about crowded trades as a precipitating cause of market perturbations, Davis’s comparison of the market to a theater (with an obvious nod to Oliver Wendell Holmes) is particularly apt. “If someone yelled ‘fire’ in a theater full to the rafters with people, panic would break out and people would get crushed. But if someone yelled ‘fire’ in a theater with very few people, the people would get up and walk out in an orderly manner. In looking at any market, it is important to determine the degree to which the market is a crowded theater or an empty one.” (p. 10)
NDR uses a wide variety of sentiment indicators. For instance, stock mutual funds cash/assets ratio, Gallup poll presidential approval rating, press headlines and magazine cover stories, presidential sentiment (how the president describes the state of the Union and the economy), AAII responses, newsletter writer sentiment, short-term bond prices, Rydex fund flows, speculator COT index, and market strategist sentiment. NDR also uses valuation measures such as the PE ratio of the S&P 500 and the ratio of the yield on the 10-year Treasury note to the earnings yield of the S&P 500 as longer-term gauges of investor expectations. Extremes in the percentage of household financial assets held in stocks can also signal longer-term reversals in the stock market as can extremes in the number of active investment clubs.
Although it is possible to chart sentiment and assign ranges to extreme optimism and extreme pessimism (for instance, above 61.5 and 50 and below in the case of NDR’s proprietary crowd sentiment poll), turning points in sentiment can only be known after the fact—the standard problem with any zigzag indicator. For instance, NDR requires sentiment to be in an extreme range and then to reverse by 10% to qualify as “an extreme.” (p. 54) As such, there’s no way to identify “an extreme” in real time. But once there is sufficient data (NDR’s chart starts in 1996) the analyst can use the average reading at optimistic and pessimistic extremes “as a frame of reference for assessing sentiment going forward.” (p. 54) Davis dramatizes what would have happened if the Monday morning quarterback had bought at sentiment highs and sold at sentiment lows between 1996 and 2002, a sample size of about 45 (I didn’t double check my counting). In every single case he would have been wrong, losing a whopping total of 5,059 S&P points! But again, it’s the siren call of the zigzag.
How does Ned Davis himself invest? He writes, “When I came into the investment business, the conventional wisdom of nearly everyone was as follows: ‘I’ve never met a rich technician.’ ‘You can’t make money short-term trading.’ ‘Eighty-five percent of people who trade options and futures lose money.’ ‘Worrying all the time about risks will paralyze you from capturing the rewards from stocks.’ . . . While my techniques are not for everyone, they were right for my psyche. I mostly use technical analysis (with heavy doses of contrary opinion); I am a very short-term trader; I make big use of options and futures; and I constantly worry about risks. And taking the road less traveled has worked for me. Since I started Ned David Research in 1980, I’ve never had a losing year on my investments.” (pp. 13-14) It may also help that he’s smart and that he clearly works hard.