Measuring market risk and opportunity
Through this presentation, you will understand a key factor in measuring the probability or risk of any investment suddenly losing significant value (especially if that market has been strong for a long time). You will also understand the opposite issue: the potential for a market to begin a sudden and lasting increase in value (especially if that market has been “dismissed” or “discounted” by mainstream investors for a long time).
The basic issue is extremely simple, though perhaps surprisingly ironic: when the masses are suddenly extremely enthusiastic about a particular market, that indicates a big increase in risk. We can call that the issue of sentiment or market saturation, which is similar to measuring the humidity of air.
When humidity (the amount of moisture in the air) is at 95% of what is physically possible, then how much higher can humidity levels rise? When humidity is 5%, how much lower can it go?
If you imagine a container full of liquid set on an dry, hot stove, then at what point is there the greatest potential to make a lot of steam? A full pot can make a lot of steam. An empty pot cannot make any steam. A pot with a small amount of liquid can only make a small amount of steam.
Next, if you have a full pot, how much more liquid can you add to that pot? Until some of the current liquid is removed (like by heat vaporizing it or by a big spoon), there is less and less potential for new volume as the pot gets fuller and fuller, right?
In terms of investment markets, the same principles apply (generally speaking). What circumstance coincides with the start of long rallies? When sentiment is unusually low (see the chart above of global oil prices), then there is a potential for a large, long increase in price.
Note that low sentiment does not predict exactly when prices will reverse or at what price level, but sentiment does indicate the percentage of investors that are currently skeptical about a market and thus could enter in (driving up prices). Sentiment (market saturation) is simply an indicator of risk and opportunity, not a predictor of specific reversal points.
In contrast, if there are very few investors who are skeptical, then there is much less potential for a long, large rally from current price levels. As shown in the chart above, the potential for a sharp drop from current prices levels (a peak) corresponds to survey responses of “above average” sentiment (as in unusual enthusiasm or “bullishness”) toward that market.
Again, only if there is a huge majority of investors who are skeptical, then prices can make the most historic increases (as the flood of trend-following investors slowly buy in to that market, resulting in a rally that is long and large). So, one of the simplest strategies of an investment analyst would be to assess a variety of markets (such as oil, US stocks, US bonds, & various currencies) in order to identify notable extremes of sentiment (market saturation).
Where markets are most saturated, once can reduce risk (by shifting to tight stop-losses or only trading a type of insurance contract called an “option contract”). Or, one can simply exit any open positions (sell) and then stay out while focusing on which markets are currently the most “discounted” (the biggest discounts, such as oil in 1999 when prices were about $11 per barrel). Where markets are least saturated (in terms of optimistic sentiment) but are rapidly rising in sentiment, such as from 9% optimism suddenly jumping to 24% optimism, that leaves a lot of potential for additional increases in optimism, right?
Note that in late 2006, when oil market sentiment hit a major low (the lowest in at least 10 years), oil prices quickly went from around $50 per barrel up to well over $100 ($148). That kind of rally is what is possible when a market is at a historic low in sentiment.
Next, back to some everyday examples, imagine that you have 5 sponges and you want to measure the probability of each sponge quickly becoming drier than it currently is. The simplest issue would be how dry (or how wet) each sponge already is, right?
If a sponge is very dry, there is very little risk of it getting much drier because it really cannot get much drier than it is. If a sponge is overflowing with wetness, then with even a very light squeeze, it could suddenly lose a lot of the liquid currently in that sponge. With a strong squeeze, a very wet sponge will pour out water, right?
If you squeeze a dry sponge, then no moisture comes out. If you squeeze a very wet sponge, then lots of moisture comes. If you squeeze a moderately moist sponge, some moisture comes out, but not as much as with a really wet sponge.
Back to investment markets, when almost everyone is already “buying in” to a particular market, then there is a very small amount of people left to go from “not buying in to it” to “buying in to it.” So, at the point of a trend reversing, the remaining opportunity for a new surge of buying is at a minimum and the potential for large amounts of selling is at a maximum.
In 2008, sentiment in oil markets reached an extreme of 90% “bullishness.” That was followed by a price collapse of well over two-thirds in several months.
Then, in late March of 2014, sentiment reached a new extreme: 91% enthusiasm (see the brown box above). There was also a record-breaking contrast between “large speculators” (who are reliably wrong at trend reversals) and “commercial investors” (AKA the smart money- those who are regularly ahead of trend reversals… perhaps because they respect the issue of market saturation). What do you think happened to oil prices after that record-breaking extreme of optimism (even more extreme than in 2008- even though prices were WAY below the 2008 levels)?
As a closing note, I have been publishing accurate forecasts of investment markets since early 2003. In 2004, I used the phrase “the dominOIL effect” to explain the sequence of events that I expected to unfold as global oil prices spiked, resulting in dramatic changes to the global economy as well as the regional economies of Europe, Asia, and North America.
In recent years, I have frequently said “prices of fuel (including gasoline) will come down again, but many people will not like the reasons why. They may rejoice at first, but that is because they have absolutely no comprehension of why fuel prices are dropping. It is because global demand, as in the global economy, is turning conservative. It is because the economic boom of the 1990s has been over for 15 years already.”
Here is a chart of global stock markets showing the peak in 2007 and a slightly higher peak in 2014. From 2009 to March of 2014, demand from an expanding global economy drove up oil prices from near $40 to well over $100 again. However, when oil prices faltered in spring of 2014, was that because a new competitor pulled “market share” away from fossil fuels? No, it was not because of something within energy markets (like airplanes worldwide converting from petroleum-based fuels to nuclear energy). It was simply because the global economy could only afford to expand again up to the point of raising oil prices to just over $100.
There may be a few sharp rallies in fuel prices of course in the near future. Global stocks might even make a new high soon. It is not impossible.
However, what is absolutely certain is that when markets are most saturated, predictable risk is at a maximum. (Unpredictable risk is a different issue, but predictable risk is very simple: extremely optimistic sentiment). In contrast, when sentiment is at a historic low for a particular market but rising rapidly, predictable opportunity is at a maximum.
For those who are so wealthy that they choose to invest in ways that ignore logic and sentiment, the rest of us thank you very much for making it so easy for us. I am not wealthy enough (yet) to be so complacent. Some people just cannot afford to be so oblivious to risk (market saturation).
If you ally with those who are complacent and negligent, your results will follow accordingly. If you ally with those who are motivated and diligent, quite different results are predictable.
Not everyone can get above average results, but someone has to do it, right? Are you interested in joining me in producing far above average results for your investments and finances? If so, I invite you to contact me and we can identify your priorities and preferences.
Note again that market sentiment is just a very basic indicator of risk and opportunity. Once I know which markets have ideal conditions regarding low risk and multiplying opportunity, there are many other issues that I use to actually select which markets to trade, exactly when to trade them, precisely how, and so on. I explore several of those issues in this video: