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PSYCHOLOGICAL INDICATORS, CONSENSUS INDICATORS
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Many private traders keep their market opinions to themselves, but financial journalists and market letter writers spew them forth like open fire hydrants. Some writers are very bright, but both groups as a whole have poor trading records.

Financial journalists and letter writers overstay important trends and miss major turning points. When these groups become bullish or bearish, it pays to trade against them. The behavior of groups is more primitive than individual behavior.

Consensus indicators, also known as contrary opinion indicators, are not as exact as trend-following indicators or oscillators. They simply draw your attention to the fact that a trend is ready to reverse. When you get that mes­sage, use technical indicators for more precise timing.

As long as the market crowd remains in conflict, the trend can continue. When the crowd reaches a strong consensus, the trend is ready to reverse. When the crowd becomes highly bullish, it pays to get ready to sell. When the crowd becomes strongly bearish, it pays to get ready to buy.

The foundations of the contrary opinion theory were laid by Charles Mackay, a Scottish barrister. He described in his book, Extraordinary Popular Delusions and the Madness of Crowds, crowd behavior during the Dutch Tulip Mania and the South Seas Bubble in England . Humphrey B. Neill applied the theory of contrary opinion to stocks and other financial

markets. He explained in his book, The Art of Contrary Thinking, why the majority must be wrong at the market's major turning points. Prices are established by crowds, and by the time the majority turns bullish, there are not enough new buyers left to support a bull market.

Abraham W. Cohen, a New York lawyer, came up with the idea of polling market advisors and using their responses as a proxy for the entire body of traders. Cohen was a skeptical man who spent many years on Wall Street and saw that the advisors as a group performed no better than the market crowd. In 1963, he established a service called Investors Intelligence for tracking market letter writers. When the majority of them became bearish, Cohen identified a buying opportunity. Selling opportunities were marked by strong bullishness among letter writers. James H. Sibbet applied this theory to commodities. In 1964, he set up an advisory service called Market Vane. He studied the opinions of advisors and also weighed them in proportion to the numbers of their subscribers.

Tracking Advisory Opinion

Some letter writers are very smart, but taken as a group they are no better than average traders. They become very bullish at major tops and very bear­ish at major bottoms. Their consensus is similar to that of the trading crowd.

Most letter writers follow trends because they are afraid to appear foolish and lose subscribers by missing a major move. The longer a trend continues, the louder letter writers bay at it. The advisors are most bullish at market tops and most bearish at market bottoms. When most letter writers become strongly bullish or bearish, it is a good idea to trade against them.

Several rating services track the percentage of bulls and bears among advisors. The main rating services are Investors Intelligence in the stock market and Market Vane in the futures markets. Some advisors are very skilled at doubletalk. The man who speaks from both sides of his mouth can later claim that he was right regardless of the market's direction. Editors of Investors Intelligence and Market Vane have plenty of experience pinning down such lizards. As long as the same editor does the ratings, they remain internally consistent.

Investors Intelligence

Investors Intelligence was founded by Abe Cohen in 1963. He died in 1983, and his work is being continued by Michael Burke, the new editor and pub-

lisher. Investors Intelligence monitors about 130 stock market letters. It tabulates the percentage of bulls, bears, and fence-sitters among letter writers. The percentage of bears is especially important because it is emotionally hard for stock market writers to be bearish.

When the percentage of bears among stock market letter writers rises above 55, the market is near an important bottom. When the percentage of bears falls below 15 and the percentage of bulls rises above 65, the stock market is near an important top.

Market Vane

Market Vane rates about 70 newsletters covering 32 markets. It rates each writer's degree of bullishness in each market on a 9-point scale. It multiplies these ratings by an estimated number of subscribers to each service (most advisors wildly inflate those numbers to appear more popular). A consensus report on a scale from 0 (most bearish) to 100 (most bullish) is created by adding the ratings of all advisors. When bullish consensus approaches 70 percent to 80 percent, it is time to look for a downside reversal, and when it nears 20 percent to 30 percent, it is time to look to buy.

The reason for trading against the extremes in consensus is rooted in the structure of the futures markets. The number of contracts bought long and sold short is always equal. For example, if open interest in gold is 12,000 contracts, then 12,000 contracts are long and 12,000 contracts are short.

While the number of long and short contracts is always equal, the number of individuals who hold them keeps changing. If the majority is bullish, then the minority, those who are short, has more contracts per person than the longs. If the majority is bearish, then the bullish minority has bigger posi­tions per person. The following example illustrates what happens when the consensus changes among 1000 traders who hold 12,000 contracts in one market.

Open Bullish Number of Number of Contracts Contracts

Interest Consensus Bulls Bears per Bull per Bear

12,000 50 500 500 24 24

12,000 80 800 200 15 60

12,000 20 200 800 60 15

1. If bullish consensus equals 50 percent, then 50 percent of traders are long and 50 percent are short. An average trader who is long holds as many contracts as an average trader who is short.

•  When bullish consensus reaches 80 percent, it shows that 80 percent
of traders are long and 20 percent are short. Since the sizes of total
long and total short positions are always equal, an average bear is
short four times as many contracts as are held long by an average bull.
This means that an average bear has four times more money than an
average bull. The big money is on the short side of the market.

•  When bullish consensus falls to 20 percent, it means that 20 percent of

traders are long and 80 percent are short. Since the numbers of long and short contracts are always equal, an average bull holds four times more contracts than are held by an average bear. It shows that big money is on the long side of the market.

Big money did not grow big by being stupid. Big traders tend to be more knowledgeable and successful than average — otherwise they stop being big traders. When big money gravitates to one side of the market, think of trading in that direction.

To interpret bullish consensus in any market, obtain at least twelve months of historical data on consensus and note the levels at which the market has turned in the past (Figure 39-1). Update these levels once every three months. The next time the market consensus becomes highly bullish, look for an opportunity to sell short using technical indicators. When the consen­sus becomes very bearish, look for a buying opportunity.

Advisory opinion sometimes begins to change a week or two in advance of major trend reversals. If bullish consensus ticks down from 78 to 76, or if it rises from 25 to 27, it shows that the savviest advisors are abandoning what looks like a winning trend. This means that the trend is ready to reverse.

Signals from the Press

To understand any group of people, you must know what its members want and what they fear. Financial journalists want to appear serious, intelligent, and informed; they are afraid of appearing ignorant or flaky. It is normal for financial journalists to straddle the fence and present several sides of every issue. A journalist is safe as long as he writes something like "monetary policy is about to push the market up, unless unforeseen factors push it down."

Internal contradiction is the normal state of affairs in financial journalism. Many financial editors are even bigger cowards than their writers. They print contradictory articles and call this "presenting a balanced picture."

For example, a recent issue of Business Week had an article headlined "The Winds of Inflation Are Blowing a Little Harder" on page 19. The article stated that the end of a war was likely to push oil prices up. Another article on page 32 of the same issue was headlined "Why the Inflation Scare Is Just That." It stated that the end of a war was going to push oil prices down.

Only a powerful and long-lasting trend can lure journalists and editors down from their fences. This happens when a wave of optimism or pes­simism sweeps the market at the end of a major trend. When journalists climb down from the fence and express strongly bullish or bearish views, the trend is ripe for a reversal.

This is also the reason why the front covers of major business magazines are good contrarian indicators. When Business Week puts a bull on its cover, it is usually a good time to take profits on long positions in stocks, and when a bear graces the front cover, a bottom cannot be too far away.

Signals from the Advertisers

A group of three or more ads touting the same "opportunity" on the same page of a major newspaper often warns of a top (Figure 39-2). Only a well-

established uptrend can break through the inertia of several brokerage firms. By the time all of them recognize a trend, come up with trading recommendations, produce ads, and place them in a newspaper, that trend is very old.

The ads on the commodities page of the Wall Street Journal appeal to the bullish appetites of the least-informed traders. Those ads almost never rec­ommend selling; it is hard to get amateurs excited about going short. When three or more ads on the same day day tout opportunities in the same market, it is time to look at technical indicators for shorting signals.

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