"...a contrarian approach is just as foolish as a follow-the-crowd strategy. What's required is thinking rather than polling." -- Warren
Buffett, Letter to the Shareholders, 1990.
Contrary to Buffett's comment, I believe that one can usefully combine thinking and polling when investing. For many years I've followed two indicators to gauge public sentiment: the
equity-only put/call ratio and the volatility index (VIX), and have found it extremely valuable to look at them in combination. When those measures indicate that investors are overly fearful and pessimistic,
I know from long experience that it's a good time to consider buying stocks.
When the absolute level of the VIX goes above 40, I know that investors are fearful and are willing to pay a high premium for their
Similarly, when the ratio of puts to calls reaches
90%, I know that amateur investors are buying a disproportionate number of puts; they're busy trying to protect themselves from further downside losses,
which is kind of like buying fire insurance while the house is engulfed in flames.
Recently a friend introduced me
to Steve Dussault's Rydex Sentiment Indicators, another set of contrary indicators that
look very interesting and useful. (Read his page to understand the construction of these indicators.) Steve only started tracking the data in the last year, so there's not a long-term record to consider,
but they look pretty promising already, and I am happy to be able to add this third contrary indicator to my bag of tricks.
In late July 2002,
when both the VIX and equity-only put/call ratio were indicating a bottom, the Arktos/OTC indicator was still quite low. Only
in October 2002 did the Arktos/OTC indicator hit 50% (a level I arbitrarily determined as significant), confirming the bottom my original
two indicators also identified. All three indicators agreed that early February 2003 was an excellent time to consider buying stocks.
"The most common cause of low prices is pessimism - some times pervasive, some times specific to a company or industry. We want to
do business in such an environment, not because we like pessimism but because we like the prices it produces. It's optimism
that is the enemy of the rational buyer. " -- Warren Buffett, Letter to the Shareholders, 1990.