Disgust to Euphoria

06/03/2005 12:00 am EST

Focus:

Chris Johnson

Editor, The Winning Edge

Although his professional title is director of quantitative research for Schaeffer Investment Research , Chris Johnson notes, "I’m a technician, a fundamental analyst, and a sentiment analyst." Here, he explains how he combines those disciplines.

"I’ve been coaching my son’s hockey team for years. When you put ten kids on the ice and they are chasing a puck, it’s chaos. This swarm of kids is going after the puck at the same time. What happens when that puck goes into the wall? You have 20 legs and 20 arms down on the ground, its just absolute chaos. We are the same way in the stock market and we tend to act just like that group of kids on the ice. What are we chasing? Profits. We tend to find safety in numbers, and we don’t want to act independent of the crowd. We wait until everyone is going in the same direction.

"And it’s not just individual investors. The average fund manager today has just three-and-a-half years of experience. A lot of portfolio managers and hedge funds are chasing the same returns and going after the same investments. They look at what everyone else is investing in before they will do anything, so that they had that safety in numbers.

They are working as a chaotic crowd. And bad things tend to happen when we follow that crowd. To invest successfully, you need to think more like the players in an NHL game, where the players are thinking independently and are working their zones. The puck moves around nice and cleanly and they can execute their plans much more effectively.

"Sometimes you miss opportunities if you just follow fundamental analysis. Earnings tripled during the period from 1970 to 1979 and the market went nowhere. Earnings were flat during the 1980s and the Dow and the other major indices tripled. The market historically rallies when growth reaches a bottom not a peak. Year-over-year earnings growth above 20% historically precedes a 1% gain on the S&P. When earnings are down 25%, the S&P index rises an average 28% the following year. The idea is that we simply can’t watch fundamentals on their own when we are trying to analyze either a stock, a sector, or the market in general.

"Right now, the market is stuck in a phase where the fundamentals are disconnected from the price action. It's in these times when we start to look at other forms of analysis such as technicals, which is a study of price activity. Here, we are looking for where a stock will find support and resistance. We focus on moving average, noting that historically, when a stock rises above certain trendlines, it leads to increased accumulation, and when it declines below that level, there is increased selling. The 50-day average is key, because a lot of institutions watch that particular trend line. The idea is that if everyone is watching that trendline and they think that average is significant, it becomes significant. It’s self-fulfilling. If I change that trendline to a 13-week or a 17-week moving average, it will lose its effectiveness.

"At Schaeffer's Research, our view is that in addition to an understanding of fundamentals and technicals, we also need to look at sentiment analysis. We call this combined approach ‘expectational analysis.’ That helps us find the sweet spot in investment. Why do we gauge investor sentiment? There are four stages of a market cycle. A market bottom is marked by absolute disgust. That is always followed by the second stage, which is disbelief when investors doubt the turnaround and question how far the rally could go. That’s a very good stage to invest from our perspective. The next stage is acceptance, when investors open their arms up and decide to take their money out of money markets and buy stocks. That’s where we start to see the rallies really get fueled by individuals coming in and buying. The fourth and last stage is a danger zone. It is marked by euphoria, where people feel they have to own stocks and can’t wait to buy more. That’s what market tops are made of.

"As the well known saying goes, markets climb a wall of worry and they slide down a slope of hope. That’s the thing to remember. It’s true. We tend to see investors throw good money into bad markets that continue to go down. It’s not until everybody turns and runs away and says ‘I don’t want stocks anymore’, that you should be buying. What drives the market higher? At its simplest level, it’s cash. With no cash on the sidelines to move stocks higher, they will languish. When investors are disgusted that means there’s a lot of money on the sidelines ready to go into the market.

"Thus, when expectations are high, it takes only the smallest negative news in order to get people to pull money out at the same time. There is a much higher chance for selling pressure when we’re in the euphoric stage. That’s what we look for with sentiment analysis. We look for disgust to euphoria. Everything in between is considered the time when ‘the trend is your friend’. But, as more and more people become attracted to a stock, a sector, or the market and it reaches the euphoria stage, that’s when you need to start taking your money out, before we see everyone run to sell.

"How do we judge this sentiment? One example is from magazine covers and stories in the press. What is the news media’s purpose? They tell us what’s going on. They are not analysts. They are not telling us what is going to happen. They report the news and tell us what has already happened. Always keep that in mind when you read articles. If we see something the media focuses on prominently, it suggests that we have reached the euphoria stage. We call this a crowded trade. Investors who act by buying when they read these stories usually represent the last push of sideline money into these situations. For us, the danger lights go on.

"We don’t use this information on its own, but we add this to other factors. For example, we can quantify sentiment by looking at options activity. Open interest put call ratios reflects the number of puts that are out there relative to calls, which in turn can show us the level of optimism relative to pessimism regarding a stock or sector of the market. Rising pessimism reflects the wall of worry and it tells us that there are still investors that are pessimistic. On the other hand, when put to call ratios go lower, it suggests that people are optimistic, which represents the slope of hope. Measures of short interest also give us signs of sentiment. The ideal buy is when there are strong fundamentals, strong price action, and low expectations as seen in sentiment indicators.

"Currently, we’re telling investors to avoid big-cap tech. The poster child is Microsoft (MSFT NASDAQ). When you look at the stock from a sentiment perspective, the put call ratio continues to go lower, price activity has done nothing. Fundamentally, the company is no longer moving forward in terms of new products. They are not pushing the envelope and reinventing products. They are just repackaging their products and applications. They’ve lost that edge that moves them forward. Fundamentally, it’s a company that shouldn’t be on a bull’s radar screens. Technically, it’s not bad, but when you look at the sentiment, 93% of the analysts who cover the stock have it as a buy or strong buy right now. The other 7% are holds. There are no sells. That’s a situation where the Street is in love with the stock. This is an overloved, fundamentally and technical weak stock. You should be avoiding it.

"Dell (DELL NASDAQ) has been a leader in the computer box area. Resistance is seen at its ten and 20-week averages. This is a stock where the analysts are piled up on the buys and the strong buys. Short interest has been going lower. The put call ratios have been going lower. Our bottom line rank is a three out of a zero to ten scale. We really expect it to underperform the market. For now, I am short Dell."

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