High Negative Investor Sentiment Usually Signals That the Time to Buy Stocks Is Near

This is one of the ideas that many investors can simply not wrap their heads around, but is a very important principle to understand if you plan on making some above-average gains in the stock market. When everyone is bearish, that usually means that it is time to buy; and when everyone is bullish, that usually means that it is time to sell.

How can this be? Wouldn't it stand to logic that if people were optimistic about the stock market that it would continue to trade higher, and if they were mostly pessimistic it would continue to trade lower?

This relates to the principle that we have talked about before; the herd is usually wrong. When the herd is selling stocks in a panic, this will almost always signal a bottom, and when they are buying in a frenzy, this will normally signal a top. Back in the early months of 2000, EVERYONE was getting into the stock market (and especially tech stocks) with almost every penny that they had. The stock market was a national obsession. Investor sentiment was ridiculously high; people were saying that Nasdaq 10k was a certainty, and that it was just a matter of time. To many market-watchers, this frenzied level of buying was a clear indication that the market was about to blow up, and it did. Reversely, when everyone was panic dumping their shares after 9/11 and investor sentiment was in the tank, this was proven to be a great time to load up on shares in just about every company. These are two extreme examples, but they illustrate the point that the herd is usually wrong, and if you become a contrarian, you will generally do fairly well.

The thing is, pending bad news gets factored into share prices well ahead of the bad news actually taking place (unless it is an unexpected, unforeseen event.) Let's take January 2008 as an example. Right now, many economists are predicting that the US will enter a recession. People hear this and think "Oh man, my shares are REALLY going to take a dive once we actually enter the recession." This isn't the case though. These stocks are taking hits right now because the market is factoring in the great likelihood of a recession. When the recession actually comes, investor sentiment will be extremely low, however the recession will have already been factored into the share price of many companies. Brighter times will be forecast, the stocks will pull out of their tailspin and start to trade higher when talk of a recession still fills the evening news.

Remember; the herd is usually wrong. Don't be a sheep. Be a wolf.

Filed under: Stock Market Education | General Knowledge