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Behavioral Finance Indicators
Here are the best three:
The ratio of advancing/declining stocks
often indicates if movements of stock market prices are broadly
based or supported only by a limited number of stocks. The broadly
based movements indicate strength while limited participation
may indicate potential weakness.
When many investors become too optimistic
about the outlook, the capital markets go through a correction
as all these optimistic participants are already fully invested,
leaving very little new money to push markets higher. Conversely,
if many investors are very pessimistic, the markets will reflect
it in lower prices, which can lure bargain hunters and push up
the markets quickly. The AAII sentiment indicator measures how
small individual investors feel about the market (i.e., bullish
= optimistic, bearish = pessimistic, or neutral). Not surprisingly,
when a large majority of small and usually inexperienced investors
have a particular feeling about the market, the opposite usually
happens.
Instead of asking less sophisticated
investors how they feel about the markets, we can simply observe
how they invest. The equity put/call option ratio is one of the
most reliable contrary indicators of the psychology of small investors.
The buyers of put options think that the market will go decline,
while the buyers of call options think it will go up. Hence, a
high equity put/call ratio indicates there is a lot of pessimism
in the market and therefore there is good potential for an upward
move. The buyers of equity options are usually small retail investors
looking for a quick return on their money. Hence, they tend to
be reliably wrong at important market junctions (e.g., over-optimism
in April 2000 and over-pessimism in October 2002).
N.B. There is no such thing as a perfect indicator and we are
always striving to improve our analysis. Please let us know if
you are aware of any other indicators that work well in the markets.
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