Sentiment & Supply/Demand A Technical Look at Behavioral Finance

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1 College Level Introduction to Technical Analysis Sentiment & Supply/Demand A Technical Look at Behavioral Finance Lecture 10 Objectives n Long-Term Sentiment of (Mainly) Investors - Asset Allocations - Flow of Funds - International Flows (International Demand) - Macro Supply/Demand - Mutual Fund Activity (Demand and Potential Demand) - Valuations (Long-Term Sentiment) n Medium-Term Sentiment of (Mainly) Traders - Put/Call Ratios (Professional and Indvidual Sentiment) - Polls (Sentiment) - Customer Transactions (Individual Sentiment) - Short Selling (Trader Sentiment) - Miscellaneous This lecture series is produced by the Market Technicians Association Educational Foundation based on the detailed class notes of Charles D. Kirkpatrick II, CMT Copyright All rights are reserved. Required Reading Master Textbook Technical Analysis: The Complete Resource for Financial Market Technicians Charles D. Kirkpatrick, CMT and Julie R. Dahlquist, Ph.D. Chapters 21; pp Additional Reading Techncial Analysis of the Financial Markets Murphy, John, pp Technically Speaking Wilkinson, Chris, pp M a r k e t T e c h n i c i a n s A s s o c i at i o n E d u c at i o n a l F o u n d a t i o n Identifying and funding educational programs in the field of Technical Analysis since 1993 MTA Educational Foundation Post Office Box Cambridge, MA / info@mtaef.org Technical Analysis Explained Pring, Martin, pp (a more detailed explanation of sentiment indicators) It Pays to be Contrary Fraser, James L., MTA Journal, November 1986 Sentimential Journey: These Old Favorites are Helpful but Can Also be Deceptive Traps for the Unwary Stack, James B., MTA Journal, November 1986 Sentiment-The Bottom Line McGinley, John, MTA Journal, November 1986 Answering the Bell of Sentiment Indicators, Leonard, Brent, L., MTA Journal, Spring-Summer 1996

2 Chart 1 Flow of Funds: Net Change in Supply of Stock Chart 2 Flow of Funds: Households Chart 3 Flow of Funds: State & Local Government Employees Retirement Funds Psychological Indicators - A Technical Look at Behavioral Finance Trend and momentum indicators tell us the direction of the trend and the force of the trend. They do not necessarily tell us where we are in the trend. Hence, we look at sentiment and supply/demand indicators to help ascertain the current position in the trend. At the beginning of a major uptrend investors are risk averse; they have only a small percentage of their financial assets in stocks and have a high percentage in bonds and cash. Traders are either out or they are short, trying to exploit the downside. An uptrend is started by investors, people with long-term horizons, willing to look beyond current uncertainties. They are motivated by price and value. Traders, on the other hand, are motivated by the trend, and tend to gain greater and greater confidence as a trend persists. Our most important long-term technical precept is Investors make bottoms; traders make tops. We define bottoms in the market as the point in a downtrend when prices start to stabilize because investment demand offsets trader liquidation. We define a top in the market as that point in an uptrend when prices stall because investment liquidation offsets trader demand. Investors tend to be right at turning points and traders tend to be wrong at turning points. During trends both classes of investors can be right for a while. Hence, we seek out indicators that give estimates of what traders and investors are doing in the market. Extremes in psychology are likely to occur near price reversals. Some of our indicators are secular (very long-term), some are cyclical (long-term) and some are medium-term. The following discussion reviews many (certainly not all) that we consider important. Long-Term Sentiment of (Mainly) Investors Chart 4 Net Purchases of U.S. Equities by Foreign Investors minus Net Purchases of Foreign Equities by U.S. Investors I. Levels Equity % of Financial Assets A. Net change in supply - high reading = excessive optimism (low reading = excessive negativism) (Chart 1) B. Households C. State & Local Government II. Flows - Equity % of Financial Assets A. Households (Chart 2) B. State & Local Government (Chart 3) Chart 5 Net Purchases of U.S. Equities by Foreign Investors III. International Flows (International Demand) A. Net foreign buying of U.S. stocks minus U.S. buying of foreign stocks (Chart 4) B. Net purchases of U.S. stocks by foreigners (Chart 5) C. Net purchases of foreign stocks by U.S. investors (Chart 6) Sentiment & Supply/Demand Lecture 10, page 2

3 Chart 6 Net Purchases of Foreign Equities by U.S. Investors Chart 7 New Equity Financing IV. Macro Supply/Demand A. New equity financing (Chart 7) B. Secondary financing (Chart 8) C. Margin debt (Chart 9) D. Insider activity (Chart 10) V. Mutual Fund Activity (Demand and Potential Demand) (Charts 11-13) A. Cash percentage - Low cash = excessive fund manager optimism B. Sales and redemptions C. Exchanges D. Total flows E. Portfolio transactions VI. Valuations (Long-term sentiment) Chart 8 Secondary Distributions: Value IV. Macro Supply/Demand A. New equity financing B. Secondary financing C. Margin debt D. Insider activity V. Mutual Fund Activity (Demand and Potential Demand) (Charts 14-18) A. Cash percentage - Low cash = excessive fund manager optimism B. Sales and redemptions C. Exchanges D. Total flows E. Portfolio transactions VI. Valuations (Long-term sentiment) Chart 9 Margin Debt versus % of Market Value Chart 10 Insider Activity Medium-Term Sentiment of (Mainly) Traders I. Put/call Ratios (Professional and individual sentiment) A. Volume Put/Call Ratios - High P/C ratios indicates excessive trader pessimism 1. CBOE indexes 2. CBOE equities B. Premium Put/Call Ratios 1. OCC equities (Charts 19-20) 2. OCC indexes B. Bond/stock relative valuations C. Bill/stock relative valuations Sentiment & Supply/Demand Lecture 10, page 3

4 Chart 11 Equity Mutual Funds: Cash Percentage of Net Assets II. Polls (Sentiment) A. Consensus (Futures Traders) - Low bullish % indicates excessive trader pessimism 1. Stocks (Chart 21) 2. Bonds B. Investors Intelligence (Market Letter Writers) (Chart 22) C. American Association of Individual Investors (Investment Clubs) (Chart 23) Chart 12 Sales (Including Reinvested Dividends) and Redemptions of Equity Mutual Funds III. Customer Transactions (Individual sentiment) A. NYSE Cash Account Buy/Sell Transaction Ratio - High ratio indicates individual investor optimism B. OTC Cash Account Buy/Sell Transaction Ratio - High ratio indicates individual trader optimism Chart 13 Net Sales of Equity Mutual Funds (Including Reinvested Dividends) IV. Short selling (Trader sentiment) A. NYSE short interest outstanding, monthly - High ratio indicated high trader pessimism B. NYSE weekly shorting activity - High public ratio indicates excessive trader pessimism (Chart 24) 1. Member 2. Specialist 3. Public V. Miscellaneous A. Speculation: OTC/NYSE Volume ratio B. Bond/stock relative valuations C. Bill/stock relative valuations Chart 14 Net Exchanges into Equity Mutual Funds Chart 15 Equity Mutual Funds: Total Flows (including ETFs as of Jan. 2008) Sentiment & Supply/Demand Lecture 10, page 4

5 Chart 16 Equity Mutual Funds: Net Purchases of Common Stock Chart 21 Consensus Inc. Bullish Percentage: Equities Chart 17 S&P 500 Dividend Yield vs. Price / Earnings Ratio Chart 22 Bulls as a % of Bulls + Bears from Investor s Intelligence Chart 18 ISE 10-Day Put/Call Ratio Chart 23 Bulls as a % of Bulls + Bears from the American Association of Individual Investors (AAII) Chart 19 Options Clearing Corp. (OCC) Equity Options Premium Put/Call Ratio Chart 24 NYSE Total Short Interest vs. Short Interest Ratio Chart 20 Options Clearing Corp. (OCC) Index Options Premium Put/Call Ratio Sentiment & Supply/Demand Lecture 10, page 5

Understanding the Technical Market Indicators

Understanding the Technical Market Indicators Revised: October 2009 Article Written By: Md Saeed Ul Hoque Golden Gate University San Francisco, CA Sharif Gias Assistant Professor of Finance University