Monday, January 21, 2008

Reading Investor Sentiment From Stock Indexes

One of the most important questions active traders can ask is whether the majority of participants in the market are risk-seeking or risk averse. This basic question of sentiment will be reflected in the relative performance of stocks and stock sectors.

In an environment of relative bullish sentiment, investors will seek growth and will be inclined to pursue riskier stocks in the hopes of greater returns. When the environment is relatively bearish, investors seek safety and move their capital to the largest, most stable issues.

Above we see two versions of the S&P 500 Index: the usual, weighted version (SPY; blue line) and the Rydex unweighted ETF (RSP; pink line).

In an environment of bullish sentiment, we'd expect the unweighted version of the S&P 500 Index to outperform its weighted counterpart. That reflects investor interest in the smaller, more volatile, more growth-oriented components of the Index. When sentiment turns bearish, we'd expect investors to seek the safety of the largest cap, most stable shares. That results in the weighted S&P 500 Index outperforming the unweighted version.

From the above chart, we see that mid-year 2007 marked an important shift in investor sentiment. To that point, the unweighted S&P 500 Index (RSP) was outperforming the standard, weighted version (SPY). Since that time, we've seen the unweighted index consistently underperforming the weighted version. During 2008 alone, RSP has fallen 1% more than SPY.

Such measures of sentiment are more reliable than simple polls of traders and investors, because they reflect the actual market behavior of the institutional investors and traders that dominate the trading of large cap equities. In my next post, we'll look at how the relative behavior of sector indexes also reflects investor and trader sentiment.


Last Hour of Trading as a Sentiment Gauge

Short-Term Patterns in SPY and RSP