investors are unduly optimistic when stock prices are high and unduly
pessimistic when they are low.
This is not a new concept either. The great investor Benjamin Gra-
ham stated more than 70 years ago, “[T]he psychology of the speculator
militates strongly against his success. For by relation of cause and effect,
he is most optimistic when prices are high and most despondent when
they are at bottom.”^29
Dave:But how do I know when the market is too pessimistic and too op-
timistic? Is that not subjective?
IC:Not entirely. Investors Intelligence, a firm based in New Rochelle,
New York, publishes one of the long-standing indicators of investment
sentiment. Over the past 40 years, the company has evaluated scores of
market newsletters, determining whether each letter is bullish, bearish,
or neutral about the future direction of stocks.
From Investors Intelligence data, I computed an index of investor
sentiment by finding the ratio of bullish newsletters to bullish plus bear-
ish newsletters (omitting the neutral category). I then measured the re-
turns on stocks subsequent to these sentiment readings.
The results, shown in Table 19-1, indicate a strong predictive con-
tent to the sentiment index. Whenever the index of investor sentiment is
high, subsequent returns on the market are poor, and when the index is
low, subsequent returns are above average. The index is a particularly
strong predictor of market return over the next 9 to 12 months.
The sentiment indicator since January 1986 is plotted in Figure 19-
- The crash of October 1987 was accompanied by investor pessimism.
For the next few years, whenever the market went down, as it did in
May and December 1988 and February 1990, investors feared another
crash, and sentiment dropped sharply. Bullish sentiment also fell below
50 percent during the Iraqi invasion of Kuwait, the bond market collapse
of 1994, the Asian crisis of October 1997, the LTCM bailout of the late
summer of 1998, the terrorist attacks of September 2001, and the market
bottom of October 2002. These have all been excellent times to invest.
It is of note that the VIX Index, the measure of implied market
volatility computed from options prices, spikes upward at virtually the
same time investor sentiment plunges.^30 Anxiety in the market, which
can be measured from the premiums on put options, is strongly nega-
tively correlated with investor sentiment.
334 PART 4 Stock Fluctuations in the Short Run
(^29) Benjamin Graham and David Dodd, Security Analysis, 1st ed., New York: McGraw-Hill, 1934, p. 12.
(^30) A discussion of the VIX Index is found in Chapter 16.