by Martin Zweig
TABLE 25
“FORECASTING” RECORD OF MUTUAL FUNDS BASED ON CASH/ASSETS RATIO: 1956 to 1996
Cash/Assets Ratio Funds “Predictions”
Date
Extreme Optimism
Extreme Pessimism
Dow *
Dow Change to Next Funds’ Extreme
Right
Wrong
July 1956 4.7% 516
-29 points X
June 1958 7.2% 487
+148 X
April 1959 4.4% 635
-57 X
September 1960 6.6% 578
+123 X
December 1961 4.3% 701
-128 X
September 1962 7.0% 573
+296 X
November 1964 4.5% 869
-60 X
October 1966 9.7% 809
+70 X
September 1967 5.2% 897
+1 X
March 1968 9.2% 898
+38 X
December 1968 6.1% 936
-191 X
July 1970 11.8% 745
+217 X
April 1972 4.6% 962
-307 X
September 1974 13.5% 655
+282 X
September 1976 4.9% 937
-124 X
March 1978 11.3% 813
+25 X
September 1978 6.9% 838
+32 X
May 1980 10.4% 870
+136 X
March 1981 8.0% 1006
-177 X
June 1982 11.7% 829
+430 X
December 1983 7.5% 1259
-158 X
June 1984 10.3% 1101
+166 X
March 1985 8.1% 1267
+168 X
October 1985 10.4% 1435
+334 X
February 1986 8.4% 1769
+68 X
September 1986 10.2% 1837
+439 X
March 1987 8.6% 2276
-323 X
April 1988
10.9% 1953
+198 X
January 1989 10.9% 2289
+415 X
February 1990 12.5% 2704
+279 X
June 1991 8.0% 2983
+430 X
April 1993 10.3% 3413
+1570 X
November 1995 7.8% 4983
+653 X
March
1996*
5636
Dow points gained on funds’ predictions: +1767
Dow points lost on funds’ predictions: -6,305
Net points lost on funds’ predictions: -4,538
As seen in the fourth column, the Dow Industrials had been 516 when the optimistic extreme was reached. About two years later, when the pessimistic extreme was hit, the Dow was 487, down 29 points from the high. In other words, the extreme optimism in July 1956 was unjustified. Instead of prices rising as the funds had anticipated, they fell.
In mid-1958, when the funds were at their most pessimistic level in several years, the market was just coming off a bottom. In less than a year the Dow ran up 148 points, reaching 635 in the spring of 1959. At that time, data for the month of April 1959 showed that the funds had reverted to an extreme of optimism once again, as their cash/assets ratio had fallen to 4.4%. Thus the funds, by having become extremely pessimistic in 1958, were wrong.
The table continues in this fashion, showing how the Dow performed between the extremes of optimism and pessimism on the cash/assets ratio. To date there have been thirty-four such extremes in the last forty-two years. In twenty-six of these cases the Dow Jones Industrials moved in the opposite direction from that which the funds had expected.
GRAPH K
Ned Davis Research
After the extreme of optimism in September 1967, the Dow managed to move up a single point prior to the pessimistic extreme in March 1968, a tiny win for the funds. After the optimistic extreme in September 1978, the market once again managed to move higher by a small 32 points before the funds reached a pessimistic extreme in May 1980. Even here that was a very dubious victory, because the market collapsed in October 1978. However, the Dow managed to go higher later, so it was somewhat above the 1978 levels at the next pessimistic extreme, in May 1980.
The seven “correct” forecasts from the funds produced a net profit of 1,767 Dow Jones points. By contrast, there were twenty-six “wrong” predictions by the funds, which totaled to a loss of 6,305 Dow points. The net loss on the funds’ predictions was 4,538 Dow points!
The data on mutual fund activity are available from a trade organization called The Investment Company Institute, in Washington, D.C. Approximately three weeks after the end of a month, the institute releases a report on the cash and assets of the various groups of funds. Please note, the Dow Jones prices in table 25 reflect the delay in getting the data; they are the prices on the third Friday of the month following the data. The funds would have looked even worse had I used the month-end prices that corresponded to the data, but since the public did not know about the cash/assets ratios for roughly three more weeks, I allowed for that delay.
Graph K (pp. 132–133) shows the mutual funds’ cash/assets ratio plotted back to 1966. There is no magic number that leaps out and tells you the ratio is so high that prices might go up, nor is any so low that it indicates prices might fall. However, by glancing at the graph you can see vividly that high ratios tend to coincide with bottoms and that low ratios, more often than not, lead to trouble. For example, near bear market bottoms in 1966, 1970, 1974, 1978, spring 1980, 1982, and 1990, the ratio got up much higher than its norm for the past few years, and prices, indeed, bottomed. Conversely, when the cash/assets ratio got low in 1967, 1971–72, and in 1976, prices moved sideways to lower.
One of the problems with the cash/assets ratio is that it tends to rise as interest rates climb because cash is more valuable at higher rates. The ratio also tends to be lower when interest rates are lower. In the late 1970s interest rates began to move upward to higher plateaus, and, as you can see, the cash/asset ratio has roamed in the range roughly from 7% to 12% in that period. Prior to the late seventies the cash/assets ratio frequently dipped into the 4% region when interest rates were substantially lower.
If you like, you can work out sophisticated adjustments for the level of interest rates; indeed, I have done so myself. But even these adjustments are no sure thing. The point here, as with other sentiment indicators, is that when you can see excessive pessimism—when anyone can observe it—it’s time to start thinking about a bull market. Or, when the optimism is overripe—and it’s easy to see it in the marketplace—you ought to begin preparing for a bear market. The idea is: Beware of the crowd when the crowd is too onesided.
INVESTMENT ADVISORS
Next to the institutions, the biggest group of players in the stock market is the general public. Many individual investors rely on investment advisors for advice, so the opinions of the advisors are often influential. Moreover, even if the opinions are not followed, they are important since a sample of advisors is really a good cross-section of the crowd in general.
An advisory service called Investors’ Intelligence, of Larchmont, New York, has been monitoring other services since 1963. At present they rate at least 140 advisory services weekly, making a determination—sometimes difficult because of the haziness of the writing—of whether the advisor is bullish, bearish, or neutral. The neutral category might include long-term bulls looking for a short-term sell-off, or some other vague classification. I find it best simply to ignore the neutrals.
I prefer making a calculation of bulls divided by the total of bulls plus bears. For example, if 60% of all advisors are bulls, 20% bears, and 20% neutral, my calculation would be 60% (bulls) divided by 80% (60% bulls plus 20% bears), which equals 75%. In other words, of those advisors clearly expressing an opinion (80% of the total), 75% are bullish.
Table 26 shows the “forecasting” record of investment advisors for the twenty-year period from 19
65 to 1993. The table is prepared the same way as table 25, on the mutual funds. The second column searches, with perfect hindsight, the optimistic extremes reached by the advisors, while column 3, again with hindsight, looks for the pessimistic extremes.
For example, on April 23, 1965, an extreme of optimism was hit when 89.7% of the advisors became bullish. Column 4 shows the Dow Jones Industrial Average at 911 at that time. The market then trended lower to 863 on July 30, 1965, the second entry on the table. On that date, pessimism had risen to where only 41.4% of the advisors were still bullish, the extreme of pessimism at that time. In the three months after April 1965, when nearly 90% of the advisors were bullish, the Dow dropped 48 points. The advisors were wrong, as signified by the “X” in the far-right column. From the pessimistic extreme in July 1965, the market began to rally, reaching 988 in January 1966. At that point 90.9 % of the advisors had turned optimistic, one of the highest readings in history. On January 26, the Dow was only 7 points under its bull market peak and had gone up 125 points from extreme pessimism six months earlier. The advisors had been wrong in their pessimism in mid-1965, and were about to be wrong in their extreme optimism in early 1966. Thereafter the Dow declined more than 200 points as a bear market unfolded.
TABLE 26
“FORECASTING” RECORD OF ADVISORS: 1965 to 1996
% of Advisors Bullish Advisors’ “Predictions”
Date
Extreme Optimism
Extreme Pessimism
Dow
Dow Change to Next Advisors’ Extreme
Right
Wrong
4/23/65
89.7 911
-48 points X
7/30/65
41.4 863
+125 X
1/26/66
90.9 988
-217 X
10/19/66
28.0 771
+158 X
9/20/67
70.6 933
-93 X
4/3/67
13.7 840
+74 X
6/12/68
69.8 914
-18 X
9/4/68
31.6 896
+70 X
12/25/68
68.8 966
-62 X
3/21/69
25.7 904
+57 X
5/16/69
61.0 961
-143 X
8/1/69
19.6 818
+42 X
11/14/69
63.1 860
-142 X
5/15/70
31.2 718
+195 X
3/26/71
85.0 913
-55 X
8/6/71
50.0 858
+55 X
9/10/71
82.1 913
-96 X
11/26/71
50.0 817
+167 X
12/15/72
85.0 1027
-127 X
6/8/73
38.8 920
+59 X
10/12/73
69.4 979
-157 X
11/30/73
35.9 822
+56 X
3/22/74
64.4 878
-191 X
8/23/74
29.1 687
+63 X
2/21/75
79.1 750
+76 X
8/15/75
46.4 826
+146 X
1/14/77
94.6 972
-196 X
2/10/78
27.6 776
+121 X
8/13/78
79.7 897
-74 X
11/3/78
29.2 823
+57 X
8/24/79
60.3 880
-74 X
11/9/79
22.1 806
+75 X
2/1/80
62.1 881
-69 X
3/14/80
27.1 812
+128 X
9/26/80
67.6 940
-4 X
2/20/80
35.9 936
+71 X
4/3/81
61.0 1007
-171 X
9/18/81
28.7 836
+20 X
11/13/81
59.7 856
-51 X
6/4/82
27.0 805
+437 X
6/24/83
82.9 1242
-118 X
6/1/84
36.6 1124
+175 X
3/1/85
82.0 1299
+30 X
10/4/85
47.7 1329
+410 X
4/4/86
86.6 1739
+31 X
9/26/86
46.8 1770
+454 X
2/27/89
83.1 2224
-230 X
10/30/87
37.2 1994
+93 X
3/18/88
55.9 2087
-131 X
5/27/88
35.2 956
+228 X
10/21/88
51.5 2184
-92 X
12/2/88
27.6 2092
+421 X
6/9/89
62.9 2513
-25 X
7/7/89
50.5 2488
+194 X
9/22/89
67.1 2682
-56 X
11/10/89
53.6 2626
+85 X
11/22/89
68.5 2711
-63 X
2/9/90
34.3 2648
+313 X
7/20/90
59.4 2961
-449 X
9/21/90
33.4 2512
+400 X
4/26/91
70.6 2912
-26 X
12/6/91
48.2 2886
+347 X
1/24/92
75.4 3233
-59 X
10/16/92
46.4 3174
+139 X
12/18/92
62.8 3313
+346 X
7/8/94
33.7 3709
+933 X
7/21/95
59.0 4612
+407 X
11/14/95
44.5 5049
+493 X
2/9/96
64.7 5542
+45 X
Dow points gained on advisors’ predictions: +985
Dow points lost on advisors’ predictions: -10,672
Net points lost on advisors’ predictions: -9,687
Source: Advisory data courtesy of Inverstors’ Intelligence, Larchmont, N.Y.
The table shows 66 times when advisors reached extremes of either optimism or pessimism in the past 31 years. Only six times—February 1975, March 1985, April 1986, December 1992, July 1995, and February 1996—did the market move in the predicted direction before the next extreme of sentiment. Using hindsight to measure the advisors’ “predictions” in the aggregate, the group was wrong 63 of 69 cases, or a success rate of just 9%—a failure rate of 91%. Had you known the extremes of the advisors’ sentiment at exactly those times, and had you followed their advice, you would have lost 10,672 Dow points in thirty-one years!
Graph L (pp. 140–141) shows the ratio of bulls to bulls plus bears going back to 1966. In this graph I’ve used a three-month average (thirteen weeks) of the sentiment. This smooths out the number so that you get a much longer-term picture. For the calculation of the thirteen-week average you simply add up the last thirteen weekly ratios and divide by thirteen. That’s it.
The graph shows, more or less, what table 26 shows, that when the bullish percentage gets too high, the market tends to head for trouble, and when it gets too low, as pessimism rises, it’s often the time to buy stocks. When the thr
ee-month average drops below about 40% bulls, it’s often a good long-term buying spot. This occurred near bear market bottoms in 1966, 1970, 1974, 1978, spring 1980, and 1982. The ratio also reached 40, or thereabouts, around the spots of intermediate-type bottoms in early 1968, late 1978, late 1979, September 1981, mid-1984, and late 1990. On the other hand, when the bullish percentage reaches 75% or so, it’s often a warning sign. This occurred in early 1966, 1971 through early 1973, 1976, and 1983. Intermediate or bear market declines ensued. High ratios in 1985 and 1986 didn’t seem to make much difference. However, when optimism got excessive in 1987, stocks crashed a few months later.
BARRON’S ADS
In the early 1970s I developed a new indicator that is the first cousin of the advisory sentiment. It’s based on the number of bullish and bearish ads that appear weekly in Barron’s, the most popular medium for advisory advertisements. During a roaring bull market you will find far more bullish ads there than is normal. There are two reasons: First, advisors, as we saw in the previous section, tend to be trend followers. So, when prices have been shooting upward for some time, the optimism among advisors grows, and it eventually shows up in the type of ads they run. In other words, a large number of bullish ads would reflect a great deal of optimism among the advisors themselves. And, as noted in the previous section, this can be the kiss of death for stocks. Second, advisors are business people. They tend to run the ads that pull the best. In a strong bull market, advisors find that bullish ads pull while bearish ads don’t.
GRAPH L
Ned Davis Research
This is a reflection of the optimism among the public that buys subscriptions to these services. Advisors don’t like to run ads that lose money, so when they find that the public wants to hear the bullish side of the market, the advisors will tend to run bullish ads. Thus, the number of bullish ads reflects the public sentiment as a whole as well as the advisors’ own preferences.
Just the reverse is true deep into bear markets. In those dreary times, very few bullish ads appear. First, it’s an indication that the advisors themselves have turned more pessimistic. Second, it is evidence that the public has also become gloomier. Generally, once the public accepts the fact that a bear market has been established, investors are not particularly interested in reading the bullish side since most are convinced that the market has nowhere to go but down. Of course, they tend to be wrong in their negative outlook when that pessimism becomes too thick.
