As investors become more pessimistic, selling in the stock market intensifies. But despite a dramatic four week plunge in the stock market, investor sentiment needs to be even more pessimistic.
Investor's Intelligence Survey; not that intelligent!
The Investor's Intelligence Survey is a measure of investment newsletters. The simple survey asks if their position is bullish (optimistic) or bearish (pessimistic). Recently, the number of bulls has been declining but the number of bears has risen only slightly. In significant corrections and bear markets it is not uncommon for the number of bears to exceed bulls.
At the current time, this measure isn't even close to an extreme. In fact, the stubborn position of investors to not become more bearish is noteworthy. What will it take to rattle investors?
The options market and how it gets it wrong.
As investors become more pessimistic they tend to buy puts in the options market. Holding puts is a strategy designed to profit from falling prices. Accordingly, the number of call options purchased diminishes due to market weakness.
As the decline in the underlying market intensifies, there has been a point historically when the number of equity puts purchased exceeds calls purchased.
You can see from the chart below that the number of puts bought nearly exceeded the number of calls (at .91 on Oct. 13, 2014). But in the last ten years, this measure has spiked to 1.20 when fear escalated. At less than 1.0, it's not quite close enough to declare fear became dominant.
What to do when investor pessimism is extreme.
When investors are "on the same side of the fence" with their viewpoint, they have carried through with either buying or selling. When investors are in agreement, the market is at a turning point. Intuitively, this makes sense if you work through it. When investors are collectively pessimistic, or bearish, they have taken action by selling their stocks. If the selling is essentially complete, then the market has only one way to go and that is up.
Our research tracks numerous investor sentiment measures as part of an ongoing study of investor behaviours. We study the link between investor psychology to market tops and bottoms. It's part of market timing and picking the biggest winners in the stock market.