How to Monitor Market Sentiment
Most indicators of market sentiment look outside the price dynamics of a particular security or index of securities for information about whether the trading crowd is humming along with expectations of normalcy or is willing to jump ship.
Here are a few outside sources you can use to gauge whether the market is bullish or bearish:
Advisors: A service called Investors Intelligence measures the balance of bullish sentiment against bearish sentiment (which it calls the bull/bear ratio) and claims an excellent track record in predicting turning points. You can find the bull/bear ratio and other indicators on hundreds of Web sites and in business newspapers. To get a specific bull/bear ratio from a specific vendor the minute it’s published, you have to pay a subscription fee.
Breadth indicators: Breadth indicators measure the degree of participation by traders in the overall market represented by an index, such as the Dow or NASDAQ. Breadth indicators include:
The ratio of advancing to declining issues: This indicator measures the mood of the market. Stocks that are reaching a higher price today than yesterday are called advancing issues. Stocks that are reaching lower prices are called declining issues. When advancers outnumber decliners, money is flowing into the market. Bulls are beating bears. Sentiment is favorable.
The difference between issues making new highs and those making new lows: If more stocks in an index are closing at higher prices than the period before, bullishness is on the rise. When a higher number are putting in new lows, supply is overwhelming demand and the mood is bearish.
Put/call ratios: The Chicago Board Options Exchange (CBOE) is the venue for options trading in equity indices like the S&P and NASDAQ indices. The CBOE publishes the ratio of puts to calls. The put/call ratio is an indicator of whether sentiment is bearish or bullish. A high put/call ratio means bears are winning. The same line of thinking holds true for a low put/call ratio: When emotions are running strongly optimistic, watch out for an opportunity to take advantage of a change.
Volatility index: Use the volatility index (VIX) as a contrary indicator. When the crowd is feeling an extreme emotion, like anxiety, it’s usually wrong. Therefore, a high VIX value means exactly the opposite of what it seems to mean — the bottom isn’t coming, it’s already in!
When VIX is low, traders are complacent; they’re projecting the same price levels, or nearly the same levels, into the immediate future with little variation and therefore little risk. When VIX is either abnormally high or abnormally low, you know it’s the right time to trade against the crowd.