The Investors Intelligence Index is a widely accepted and valuable tool for investors seeking to gauge the sentiment in the stock market. Established in the 1950s and refined in the 1960s, this index plays a pivotal role in helping traders understand the prevailing balance of power between the bulls and bears in the market. It serves as a critical contrarian indicator, offering insights into potential market reversals.

Advisor Sentiment

Contrary to its name, the Investors Intelligence Sentiment Index doesn't refer to individual investors' sentiment but rather focuses on advisor sentiment. Specifically, it compiles forecasts from newsletter writers to determine the overall market sentiment. This approach is rooted in contrarian principles, suggesting that traders should act against the consensus of expert opinions and market trends.

Chartcraft, the company behind the index, analyzes more than 100 newsletters to calculate the Investors Intelligence Sentiment Index. This unique approach assumes that a consensus trend is prone to reversal, creating opportunities for traders to profit from impending changes in price movement. The strength of reversal signals is highest when market sentiment is heavily skewed in one direction, either extremely bullish or bearish.

The Sentiment Index Ranking

To make the index more actionable for traders, Chartcraft employs a ranking system, assigning numerical rankings to various indicators, including the sentiment index. Extreme bullishness is denoted by a ranking approaching -10, indicating a potential downward shift in the market's direction. Conversely, extreme bearishness is represented by a ranking close to +10, suggesting an imminent market upturn led by the bulls.

Negative rankings for the sentiment index range from -1 (indicating that the bulls are at 51% or higher) to the maximum of -10 (when the bulls exceed 60%). These rankings provide traders with insights into market sentiment dynamics, but it's essential to note that these thresholds are specific to the sentiment index and may not apply universally.

On the other hand, if the bullish sentiment falls below 45%, a +1 ranking is assigned. When bulls dip to 36% or lower, the highest reading of +10 is given. Similarly, a -10 ranking is assigned if bearish sentiment falls below 20%, and this ranking persists for three months. The sentiment weighting can reach a maximum -20 ranking in this manner.

Index Swings

Investors Intelligence also tracks rare events in the market. For instance, if bearish sentiment exceeds 55%, an additional +10 is added to the ranking for a six-month duration. An example of this occurred in December 1994 when bullish sentiment reached over 59% for two consecutive weeks, marking the highest level of bullishness recorded by the index in over a decade.

Academic Research

Despite its popularity, the Investors Intelligence Sentiment Index has faced scrutiny. In the early 2000s, a study by researchers from the University of Santa Clara, including Ken Fisher and Meir Statman, found only a weak correlation between the sentiment of newsletter writers and major market turning points. They stated, "We found the relationship between the sentiment of newsletter writers as measured by the Investors Intelligence survey and future S&P 500 returns to be negative but not statistically significant."

However, it's essential to understand that like any indicator, the sentiment index is not a foolproof predictor. Market sentiment often remains within a normal range where it offers no meaningful trading signal. For instance, Investors Intelligence considers a typical range to be 45% bulls, 35% bears, and 20% corrections, which falls within a neutral reading.

In summary, the Investors Intelligence Sentiment Index remains a valuable tool for investors, offering unique insights into market sentiment and the potential for reversals. While it's not a guaranteed indicator of market direction, it provides a valuable perspective that, when combined with other data points, can help inform investment decisions. Successful investing involves a comprehensive approach that considers various factors, including market sentiment, to make informed choices aligned with your financial goals and circumstances.

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