We may not listen to such advice in the heat of the moment – in fact by definition we do not on average – but we’ve all been told that it’s wise to go against the crowd during extremes in stock market sentiment.

Whether it is through old chestnuts such as Baron de Rothschild’s “buy to the sound of cannons, sell to the sound of trumpets” or the Oracle of Omaha’s more modern advice to “be fearful when others are greedy and greedy when others are fearful”, avoiding the madness of crowds is hardly a novel idea.

This is fine as far as it goes, but true market panics or manias and their opportunity for rich profits or avoidance of crippling losses come perhaps once or twice a generation.

What about the numerous smaller peaks and valleys in-between? They are hard enough to identify for individual stocks – how many predictions were there that Apple shares were frothy $50 or $100 ago? – but tools exist. For example a classic paper, Dumb Money by Owen Lamont and Andrea Frazzini identifies frothy stocks or sectors based on mutual fund inflows.

If getting it right on the scale of a single stock is tricky, then doing so for the market as a whole should be far harder. Many traders track data such as equity mutual fund inflows for clues but this has a spotty record.

Consider how well precious metals and bond funds have done while absorbing record inflows in the past several months. But there is at least one freely available indicator that nicely captures the public mood: the American Association of Individual Investors weekly sentiment survey. This non-profit investor education group allows its 150,000 paying members to vote once a week on how they think stocks will do in the next six months.

Some 58 per cent of respondents said they were “bullish” about equities in the survey conducted during the week ending November 10, a rise of 9.3 percentage points and the highest since early 2007. Since the survey began in 1987, there have been only 65 weekly observations with a higher percentage of bullish respondents, placing the current mood near the top 5 per cent overall.

Such optimism is most assuredly not a good sign. On average, the S&P 500 lost 2 per cent in the year after such a high reading. Among the most bullish weeks overall were surveys just before the 1987 and 2000 stock market crashes. Overall, the market was lower 30 out of 65 times, a very bad ratio.

By contrast, if one looks at the 65 instances when bullishness was lowest, there were only three times that stocks were lower a year later and all three came in 2008, before or during the Bear Stearns crisis.

This was a prelude to bigger problems at Lehman, AIG and elsewhere that year and a market bottom in March 2009. Even including these big drops, the market rose by an impressive 15.2 per cent on average after lows in bullishness.

Of course this is an erratic series and many respondents report that they are “neutral” each week. But some savvy market watchers have included the AAII survey in more complex timing models.

Indeed, the last peak in AAII bullishness coincided with a prescient warning from fund manager John Hussman, a former finance professor who has outperformed the market in part by being hedged when conditions seemed unfavourable.

The most extreme set of negative conditions on his spectrum are dubbed “hazardous ovoboby”, short for “overvalued, overbought, overbullish conditions, coupled with upward pressure on yields”.

The January 2007 peak came several days before a sharp market plunge and the initial brush fires of the subprime crisis that would soon engulf the markets.

Dr Hussman’s ‘ovoboby’ conditions prevailed just before a veritable rogue’s gallery of market swoons such as April 1965, January 1973, August 1987 and March 2000, plus a handful of false alarms. Not all the criteria exist today but he is cautious nonetheless.

Still, with leading stock indices hitting two-year highs recently and investors having bought furiously ahead of last week’s announcement of quantitative easing, one can almost hear the trumpets.


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