Sentiment indicators are meant to demonstrate how a group of investors and traders feel about the markets.
- This group might be “dumb money”, which suggests that you should trade opposite to what the prevailing sentiment is.
- This group might be “smart money”, which suggests that you should trade according to what the prevailing sentiment is.
The majority of sentiment indicators are “dumb money” sentiment indicators. These indicators become “optimistic” after the market goes up and “pessimistic” after the market does down. Hence, these are essentially used as contrarian indicators.
We’ve already said that sentiment indicators aren’t the best. But if you’re still interested in them, here are some common sentiment indicators for the stock market and other financial markets. Most sentiment indicators are designed for the stock market because it captures the majority of investors’ attention. Not many mom-and-pop investors trade forex and commodities.
Stock market sentiment indicators
VIX (volatility index)
VIX is the most commonly used sentiment indicator for the stock market. VIX is essentially a “fear index”.
- It rises when the majority of investors and traders are more pessimistic and expect higher volatility in the stock market.
- It falls when the majority of investors and traders are optimistic and expect lower volatility in the stock market.
In other words, VIX tends to move inversely with the S&P 500 over the short-medium term.
VIX is based on options. VIX tends to swing within a range over the long run. It bottoms at around 10 and it rarely goes above 40.
This is a price-based sentiment indicator for the U.S. stock market. This is used as a “dumb money” contrarian indicator.
AAII Investor Sentiment Survey
AAII is one of the best survey-based sentiment indicators for the U.S. stock market. Every week AAII members are asked in what direction they think the U.S. stock market will go over the next 6 months. The results are compiled into Bullish, Neutral, and Bearish. Here’s what it looks like.
This is used as a “dumb money” contrarian indicator.
S&P 500 Put/Call Ratio
The Put/Call ratio shows the volume of Put options vs the volume of Call options. Put options bet on a decrease in the stock market. Call options bet on an increase in the stock market. The higher the Put/Call ratio, the more “pessimistic” traders are. The lower the Put/Call ratio, the more “optimistic” traders are.
This is used as a “dumb money” contrarian indicator. But unlike AAII and VIX, the Put/Call ratio is a more short term sentiment indicator. It’s more useful for picking short term extremes in the market.
The market’s price itself
There are other common sentiment indicators like “the number of stocks on the NYSE at 52 week highs minus the number of stocks at 52 week lows”. All of these sentiment indicators are very similar.
- Sentiment is “optimistic” if the market’s price keeps going up. This is seen as a sign that contrarian traders should be bearish.
- Sentiment is “pessimistic” if the market’s price keeps going down. This is seen as a sign that contrarian traders should be bullish.
This is my biggest problem with sentiment indicators. I don’t need to an indicator to tell me if the masses are bullish or bearish. If the market is going up, then the majority of investors and traders are probably bullish/optimistic. If the market is going down, then the majority of investors and traders are probably bearish/pessimistic.
Commodities and forex sentiment indicators
The COT Report is the best sentiment indicator for commodities and forex markets. The COT reports breakdown how various groups of market players are positioned in the futures markets.
Of these groups…
- Speculators are considered “dumb money”. A massive net short position is seen by contrarian traders as a bullish sign for the market. A massive net long position is seen by contrarian traders as a bearish sign for the market.
- Commercial hedgers are considered “smart money”. A massive net short position is seen by contrarian traders as a bearish sign for the market. A massive net long position is seen by contrarian traders as a bullish sign for the market.
In essence, speculators (“dumb money”) are trend followers while commercial hedgers are contrarian. Speculators like to trade with the prevailing market trend while commercial hedgers like to trade against the prevailing market trend.
Note: the COT Report is a useful sentiment indicator for the commodities and forex markets. It is not useful for the stock market. There is no group of market players (Speculators vs. Commercial Hedgers) that’s consistently better at timing the stock market.