CHAPTER 1

Reverse Psychology

The more you study the stock market, the more you'll realize it's fueled by thefear, greed, and hope of millions of market participants. So it should not besurprising that the market indicators in this chapter are used to monitor whatthe crowd is feeling.

These indicators are perhaps the easiest to read and understand, but they cangive you the most revealing clues, especially at market extremes. Knowing whenthe crowds are panicked or over-confident is essential if you are going to enterthe market. The stock market is psychological warfare, and you'd better knowwhat others are thinking before you enter.

The following indicators are commonly referred to as sentiment indicatorsbecause they monitor the sentiment, or psychology, of the market. And as you'llsoon find out, it's an Alice in Wonderland kind of world, where up is down anddown is up.

Traders and investors closely follow the first indicator, the AAII SentimentSurvey.

AMERICAN ASSOCIATION OF INDIVIDUAL INVESTORS

Name: American Association of Individual Investors (AAII)

Where to find: www.aaii.com/sentimentsurvey, Barron's, Forbes,and other financial periodicals

Time period: Weekly survey

The Lighter Side: The AAII Sentiment Survey, which I nicknamed "TheLittle Guy," will keep you out of trouble when the markets get extreme. A littlesecret: do the opposite of the little guy.

WHAT AAII DOES

AAII polls their members via the Internet to find out how the members feel thestock market will do over the next six months: bullish, bearish, or neutral.

HOW TO READ AAII IN FIVE MINUTES

Go to www.aaii.com/sentimentsurvey to read the survey results. It willlook something like Figure 1.1.

1. Buy: When AAII members are over 50 percent bearish, you may buy. At 60 or70 percent, it's a screaming buy.

2. Sell: When AAII members are over 60 percent bullish, you may sell. At70 percent, it's a screaming sell.

3. Note: These are not actionable trades, but only guidelines. Alwaysuse other indicators to confirm before buying or selling.

THE BACK STORY

AAII is a nonprofit educational organization founded in 1978 by James Cloonan.Members are typically nearing or in retirement and have a relatively high networth. One of the organization's goals is to educate individual investors tomanage their own portfolios.

In 1987, AAII started polling individual members each week about the stockmarket. Before the Internet, random AAII members were polled by postcards; since2000, all members have to do is vote online.

It wasn't long before the financial world discovered that the poll results couldbe used as a contrarian indicator. In other words, if members are feelingexcessively bullish or bearish, traders could do well by doing the exactopposite.

WHY THE AAII SURVEY WORKS

There is nothing more fascinating than getting inside the heads of individualinvestors. After all, the market is driven by twin emotions of fear and greed,as pointed out by traders such as Jesse Livermore or investors such as WarrenBuffett.

Therefore, it is not surprising that one of the most watched is the weekly AAIISentiment Survey. The results are published on the AAII Web site or in financialperiodicals such as Barron's and give insights into the mind of thelittle guy. At times, the survey can be uncannily accurate—that is, it canbe if you do the opposite of what the members are feeling.

"The survey gets interesting when we see levels of excess," says CharlesRotblut, vice president and AAII Journal editor. "It might not be theexact bottom but that first high reading is a definite sign you should belooking for confirmation. In other words, look for additional signs to supportyour contrarian belief, such as valuation, changes in earnings estimates, andchart formations."

If you graph the results on a chart, says Rotblut, you are looking for resultsthat are at least two standard deviations away from the mean. One standarddeviation would be on the outer edge of normal. Two standard deviations andmembers are feeling either scared they'll lose their portfolio or giddy by howmuch money they're making. At three standard deviations, the survey reallyshines. For example, one of the highest readings of all time was 70 percentbearishness. The following year, the market zoomed up over 80 percent.

Typically, says Wayne Thorp, senior financial analyst of AAII and editor ofComputerized Investing, "when you start hitting 60 percent sentiment onthe bearish or bullish side, your ears should perk up."

Historically, that means the market is hitting an extreme. "I think over theshort term the market is completely driven by sentiment," Thorp cautions. "Incase of extremes, the fundamentals tend to go out the window."

The survey seems to work as a contrarian indicator because it's not just themembers who are feeling extreme emotion but also the majority of the people inthe stock market. And yet, it's hard to do the opposite of how you feel.

"At a certain point," Rotblut explains, "members succumb to irrationalexuberance or are overwrought with fear about what is going on in the markets.The hardest thing for someone to do is to buy low and sell high, even thoughstudy after study shows that you should be greedy when others are fearful andfearful when others are greedy, to paraphrase Warren Buffett. When you'relooking at the balance of your account plummeting, or you're looking at itjumping in value, it's really hard to take a stand against the tide. It's humanemotion."

One suggestion from Rotblut is that during the next bull market, write down whatyou will do in the next bear market. "When people are not under stress, theymake rational decisions. But when they are under stress, they tend to makeirrational decisions. They let their emotions take over."

It's hard to step in and buy when you're losing money in the middle of a bearmarket, he says. "From an emotional standpoint, it's extremely hard to do. Froma financial...