Reader Erik asks a good question regarding investor sentiment. In particular, he wanted to know how bullish investors became during bear market rallies during 2008 and 2009. We will do our good reader one better, and look at the behavior of the sentiment indicator during the 2001 to 2002 bear market as well.
Before getting to specifics, let me first address several things about investor sentiment. It is my belief that most market participants look at investor sentiment as giving them some information about when a market will change direction because there are too many buyers or sellers on one side of a trend. In other words, if we can only determine when there are too many investors on one side of a trade then we could capitalize on that information by betting against the majority. But this interpretation is too naive. There are plenty of examples where trends change direction as investors become extremely bullish or bearish, and there are sufficient examples of trends moving higher or lower despite the extremes in investor sentiment as the old extremes (where the market use to change course) don’t apply anymore.