Diffusion and sentiment

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Information paralysis can be resolved by sentiment indicators which can not only predict but also time market turns.

These two generic sounding terms""diffusion and sentiment""are going to redefine the forecasting business in times ahead. Diffusion might sound familiar to economists as it's also an econometric technique.

But omnipresent sentiment measurement or sentiment indices are not only unpopular but also under-researched.

In emerging markets like India and China, they don't even exist. Internationally, there is not a single book available on the subject. And a web search on sentiment will take you to poetry.

This reminds me of the scene from Asimov's screen adaptation I, Robot where Del Spooner (Will Smith) asks Dr Alfred Lanning's (James Cromwell) hologram, "What do I see here?" Lanning's hologram says, "My responses are limited; you have to ask the right question."

So even if you have the right question, the available answer may be insufficient. It is this insufficiency researchers are struggling with to come with the right forecast.

Information in itself has failed us, as stock prices react to so many factors that even regional fundamental analysts have started looking at the movement of the Dow Jones to gauge market trends.

Not very many can disengage from international events and talk about markets or assets on a stand-alone basis. It's a clear case of information paralysis. Less is not enough and more is overwhelming. And web searches really don't help further the search of what really works or how to see through this clutter.

Web search is a clutter where 'loss' is about weight not about finance, history is not about economics as in econohistory, valuations are about data not about fractals. The search engine's responses are limited.

It was to see through this chaos that sentiment and diffusion indicators were first designed in 1960s. Are questions on diffusion and sentiment indicators the right ones?

This question was partially answered by a client of ours, a national bridge champion, "This 80-20 theory is perfect--if most of the people do one thing, you do the opposite."

Conventional logic might make you laugh at this, but the champion is an intermediate term investor. He is always looking around for sentiment cues from newspapers, big bank securities' company recommendations, local economic news, international updates etc.

After that he gauges the sentiment, which side is heavier, the positive or the negative side. I don't know how he measures it in his mind, but he surprises us with his uncanny sentiment indicator. It works. He is a good pattern recogniser, a contrarian and this he mixes with a sentiment study.

Diffusion indices are built in the same way. These are survey indicators. Talk to 100 experts and take their opinion for the day. If 80 per cent are on the positive side, we have reached a top and vice versa.

Technical expert Martin Pring says, "Sentiment observations are as valid for intermediate term (multi-week) peaks and troughs as they are for primary ones (multi months)."

The difference is normally of degree. At an intermediate term low, for example, significant problems are perceived, but at a primary market low, the problems often seem insurmountable.

In some respects, Pring adds, "The worse the problem, the more significant the bottom." He even clarifies that though sentiment indicators work well, it is best to monitor several sentiment indicators simultaneously.

The Advisors' Sentiment Report has been one of the leading sentiment indicators constructed by Investors Intelligence since 1963. The indicator has a consistent record for predicting the major market turning points.

The report studies over a hundred independent market newsletters and assesses each author's current stance on the market: bullish, bearish or correction.

Current readings are put into context against historic precedents. Signals generally arrive when you need them, near important market tops and bottoms.

Conventionally, the best time thought to be long on the market is when most advisors were bullish. This has proved to be far from the case; a majority of advisors and commentators were almost always wrong at market turning points.

Quite simply, professional advisors are just as susceptible to market emotions as individual investors. They become far too greedy at the top of trends and far too fearful near the bottom.

The contrary indicator only works at extremes. A large part of the time the Advisor's Sentiment report readings remain neutral i.e. 45 per cent bulls, 35 per cent bears and 20 per cent neutral. Advisors are only wrong when you get too many of them to start thinking the same thing. Back in October 2002, there were many more bearish than bullish advisors.

Historically, this has always been a good time to start thinking about buying the market. Investors would clearly find it more profitable, then, to take a position contrary to the advisory service industry. But then as we said earlier, advisors as a group invariably go wrong.

There are other sentiment reports published in the US like the Bullish Consensus newsletter by Market Vane, which has been around since 1964, well before contrarianism was really written about.

There are a host of other indicators like specialist/public ratio i.e. smart money against not so smart money. Then there is the short interest ratio, inside sell/buy ratio, mutual fund cash/asset ratio, margin debt trends, put/call ratios, inverted dividend yield momentum and volatility indicators.

So, on one side we have sentiment readings and survey findings and on the other hand, experts who fight about lack of information or its excess. Very few of them ask, "Why do you need information anyway?"

Studying sentiment is fun. It teaches you about social behaviour, mass psychology, error-prone humans, overestimation of skills, biases, overconfidence and above all herding.

"This time it's different," gets a large number of search results. We keep fighting for intellectual supremacy while the market needs a simple study of sentiment to see through the chaos and layers of leverage, which can end your investment life. Investors come and go. Some never came after the 2000 crash and some got burnt in small dips in May 2006 and July 2007.

Nobody looks for them and writes about them. And they never come back to the market; not because the market is not a great place to be, but because to survive the market till you die and pass the art of investment to the next generation needs more than information access. It needs the ability to understand market sentiment and ask the right question.

The writer is CEO, Orpheus Capitals, a global alternative research company