The Smoking Gun

What's up with Barron's love affair with Amgen? Does Forbes really think that Google will be unseated by its Chinese rival, Baidu? Option traders are snapping up calls on United States Natural Gas Fund—so they're optimistic, right?—but short interest on the exchange-traded fund is near an annual high. What do the shorts see that call buyers are missing? Could they possibly be looking at the same things? And why on earth are traders buying puts on Macy's after its better-than-forecast earnings report?

Welcome to the wild, wonderful field of sentiment analysis. In previous editions of SENTIMENT, we introduced you to Expectational Analysis®, our three-tiered methodology for analyzing stocks, and we reviewed some basic concepts of fundamental and technical analysis (two of those three tiers).

But, to revisit a metaphor we used in the first part of this series, fundamental analysis and technical analysis together are like a two-legged stool: it won't stand up very well without help from a third leg.

That's where sentiment analysis comes in. Fundamental analysis and technical analysis can provide a wealth of information about a company's financial health and its past performance on the charts. But they both overlook one critical factor: investor psychology. This final element is our "X Factor"—it not only helps to fill the gaps left by technical and fundamental analysis, but it can also provide you with an entirely new insight into the market.

Any serious trader can probably recall a time when he made an investing decision based not on intellect, but on emotion—whether it was panic, greed, fear, or Alan Greenspan's personal pet peeve, irrational exuberance. In fact, this probably happens more often than most of us would like to admit. And with traders around the globe making emotional decisions on a regular basis, the price of any given stock can be considered nothing more than investors' collective perception of reality. Those perceptions can change with blinding speed.

Our view of sentiment analysis is strongly colored by our contrarian philosophy. Simply put, our antennae are up when the investing crowd appears to be reaching an extreme in either bullish or bearish sentiment, especially when this sentiment runs counter to the direction of the stock. For example, pessimism would be an expected reaction to a downtrending market, and would therefore not be a valuable contrarian indicator. On the other hand, skepticism amid a rising market is a potentially powerful bullish combination, as market tops are usually not reached until optimism reaches extreme levels.

In other words, we're not knee-jerk contrarians—that is, we don't go against the crowd just to be difficult. Instead, we try to pinpoint opportunities where Wall Street's prevailing attitude toward a stock or sector seems out of line with the technical and fundamental prospects for that equity. Only then can we capitalize on a gradual reversal of sentiment, as traders are forced to capitulate to the stock's trend.

SENTIMENT INDICATORS

Let's look at some of our favorite sentiment indicators. Taken in context, these tools provide successively more sophisticated guidance.

Media: Magazine cover stories are one of our favorite sentiment indicators, partially because of the time lag involved in print publications. By the time a stock garners a cover story—whether bullish or bearish—it's likely that the trend has been in place for quite a while. For example, if the latest issue of Forbes or BusinessWeek features a pessimistic cover story on the troubles of XYZ Company, it very likely means that these negative factors are already priced into the stock. Even more telling is when a general-interest, non-financial publication devotes its cover to an investment-related issue. Naturally, our antennae went up in spring 2009 when Vanity Fair featured a series of covers on the financial crisis.

Surveys: We regularly review the sentiment surveys conducted by organizations such as The American Association of Individual Investors (AAII) and Investors Intelligence. As with magazine cover stories, these surveys can offer excellent contrarian readings at extremes. For example, in the midst of the massive March-through-November rally of 2009, the AAII poll published November 5 found only 22% of those surveyed were bullish on the market. The next day, the Dow Jones Industrial Average closed above 10,000 on a weekly basis for the first time since October 2008.

Analyst rankings provide a quick snapshot of Wall Street's current outlook for a stock. If a security boasts 17 "strong buys," five "buys," just two "holds," and no "sells," it's safe to say that brokerage firms are predominantly optimistic. If the shares are trending higher, that's great—but if they're stagnating beneath technical resistance, or perhaps the fundamentals are a bit shaky, it opens the door for potential downgrades. Analyst downgrades frequently incite fresh selling pressure, while upgrades often bring new buyers to the table. As a result, we're always on the lookout for scenarios where these ratings don't seem to jibe with the equity's performance.

Short interest offers a quick-and-dirty snapshot of investor sentiment by measuring how many traders (often of the hedge-fund variety) have sold the stock short. As more players place their bets against the stock, short interest will rise. So, a high volume of short interest generally indicates a bearish outlook. From a contrarian viewpoint, we see this pessimism as bullish for the stock if it is in an uptrend. That's because a substantial accumulation of short interest can unravel in the form of a "short-squeeze rally," as pessimistic players are forced to repurchase the shares that they "pre-sold" to control their losses.

Open interest configurations—or, the level of open option positions at the various strike prices for the various expiration months—can provide a glimmer of insight into option players' attitudes. When traders are favoring out-of-the-money calls, for example, it could mean that the bulls are banking on a major rally. It's also important to note heavy accumulations of near-the-money call and put open interest, because these build-ups can affect the price action of the underlying equity. Specifically, heavy call open interest can exert options-related resistance as expiration draws closer, while substantial put open interest can act as a floor for the stock. Taking this option open interest analysis one step further, we developed the Schaeffer's put/call open interest ratio (SOIR). The SOIR compares total put open interest against total call open interest among options set to expire within three months, because these shorter-term bets tend to be more speculative in nature. Readings above 1.00 indicate that puts are more prevalent, while readings below 1.00 reveal that calls are predominant. The idea is to assign a single number to the sentiment of option traders, with a SOIR above 1.00 indicating unusual pessimism.

"Buy-to-open" option volume ratios are among the newer tools in our sentiment analysis arsenal. The Chicago Board Options Exchange (CBOE) and the International Securities Exchange (ISE) provide us with daily statistics on how many puts and calls have been bought to open over various time frames. In other words, this represents the activity of option buyers, and excludes the opening activity of those who are selling options. As a result, we obtain a much clearer view of the sentiment of everyday option traders who are speculating by buying calls or puts, which can be very helpful in a contrarian analysis.

PUTTING IT ALL TOGETHER

Of course, the most important context for any sentiment indicator is the equity's fundamental and technical backdrop, which completes the Expectational Analysis picture. But be careful not to make snap judgments based on extreme sentiment independent of its counterparts if they're telling a different story. For a high-profile example, let's hearken back to mid-2007 and the highly anticipated debut of Apple's iPhone (see Figure 1). The device was so relentlessly hyped that it garnered the nickname "Jesus Phone" before it even hit store shelves—suggesting rather lofty expectations. I remember watching the stock's SOIR hit a succession of new annual lows around this time, indicating that option players were leaning heavily toward buying calls and confirming that bullish sentiment was running wild toward Apple shares.

It's important to note that in this particular case, this raging optimism didn't backfire, and those who positioned themselves for a contrarian decline in the shares were blown away. Apple extended its uptrend on the charts through the end of 2007, capitalizing on solid technical support from its 10-week and 20-week moving averages. It also didn't hurt that the iPhone was well-received by consumers—in fact, research firm Strategy Analytics recently reported that Apple became the top cell phone maker by profit within just two years of the device's launch. In this case, bullish sentiment had reached near-epidemic levels on Apple stock... but because the upbeat attitude was justified by the strong technical and fundamental performance, there was no backlash from disappointed investors. This is also an excellent illustration of the importance to contrarians of focusing on counter-trend sentiment for their actionable ideas.

ONE FINAL POINTER:

While it's easy to get caught up in the excitement of sentiment sleuthing, it's important not to get carried away. As Freud famously observed—albeit on an entirely different topic—sometimes a cigar is just a cigar. In short, you don't need to lose too much sleep worrying about the contrarian implications of Beyonce's June 2009 Forbes cover. On the other hand, there is that infamous jinx for athletes who appear on the cover of Sports Illustrated...