Understanding and Trading the Investor Sentiment Cycle

By: Wayne Duggan

The stock market routinely experiences rallies, pullbacks, all-time highs, corrections, and bull and bear markets. One excellent indicator of where the stock market is in its cycle at any given time is investor sentiment.

The Investor Sentiment Cycle
Investor sentiment is simply the way investors collectively feel about a stock or the market as a whole. When investors collectively believe stock prices are headed higher in the near term, investor sentiment is high. When they believe stock prices are headed lower, investor sentiment is low.

However, the counterintuitive part about investor sentiment is that it is generally a contrarian market indicator. Peak investor sentiment typically corresponds to market tops, whereas troughs in investor sentiment typically correspond to market bottoms. In other words, times when investors feel most confident stock prices are headed higher are often the worst possible times to be buying.

Phases of the Sentiment Cycle
Traders can find countless direct gauges of investor sentiment via a quick Google search. However, traders that are involved with trading communities online and on social media can also monitor the general tone and emotions in posts and comments. Even your own personal emotions toward the market and your own portfolio can be a valuable measure of investor sentiment.

The middle of the investor sentiment cycle typically corresponds to the times when investors are most analytical and least emotional.

As stock prices rise, cautious optimism will turn to feelings of excitement, thrill and even euphoria.

Once stock prices start to fall, those feelings will tend to turn to anxiety, fear and depression. Troughs in the investor sentiment cycle typically correspond to emotions such as panic and eventually despondency. These are the periods in which you may feel like investing in the first place was the dumbest mistake you have ever made.

Trading the Cycle
Successful long-term investors, such as Berkshire Hathaway (NYSE: BRK.A) (NYSE: BRK.B) CEO Warren Buffett, have long understood the implications of the investor sentiment cycle.

“Be fearful when others are greedy and greedy when others are fearful,” Buffett once famously said.

As Buffett suggests, traders playing the investor sentiment cycle should be buying stocks at times the market outlook seems the darkest. This strategy worked great in mid-March 2020 when the pandemic outbreak was at its worst.

However, with the S&P 500 now trading at all-time highs roughly a year later, the fact that there seem to be so many people out there these days feeling like investing geniuses could be a potential red flag that traders should stay watchful for a cyclical peak in investor sentiment.

The author is long BRK.B.
I don’t know if they want third-party graphics or not, but this is a good one I found here: https://seekingalpha.com/article/225673-investor-sentiment-cycle-a-survey

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