In this part, we analyse the ‘market sentiment’. This is very interesting to do it because this index is considered as one of the best contrarian indicator. Why is is a contrarian indicator? Because when everyone is bullish, there is a high probability that most investors are already invested in the market. So, the risk is to the downside. At the opposite, when everyone is afraid, there is a high probability that investors are in panic mood, and we are maybe close to a bounce back.
We have the same situation with the volatility. Why? Corrections/bear markets are going fast and take most investors by surprise. So, bear markets are often coupled with rising volatility. At the opposite, bull markets take a long time to exhaust, they are much more progressive and most of the time they are coupled with declining volatility.
So, in order to score the market sentiment, we analyse those 2 parameters: investors’ sentiment and market volatility.
In order to score the investor sentiment, we compute each week the difference between the percentage of bullish investors (on a 6months time horizon) and the percentage of bearish investors (on a 6 months time horizon).
So, when this difference is much more positive than historical metrics, we consider investors can be too complacent and we rate the sentiment at ‘1’. At the opposite, when the difference is much more negative than historical metrics, we consider investors can be in panic mood and the market can be close to a bottom. In this case, we rate the sentiment at ‘5’.
We have roughly the same approach for volatility than for investors’ sentiment: we consider that when volatility is extremely high (relative to historical standards), this means that investors are in panic mood. So, the market can be close to a bottom and we score it at ‘5’.
At the opposite, when volatility is extremely low (relative to historical standards), we consider investors are maybe too complacent and the risk is probably to the downside. So, we rate the market at ‘1’.