Investor sentiment has become the focus of many studies on stock market pricing, most suggesting a contrarian stance offers the best chance of success because the market, in the near term, rarely does what the majority expects it to do. Consequently, when inves-tors are wildly optimistic, the advice is to bail out; when investors are truly gloomy, start buying because most will have bolted, removing potential selling pressure that could drive the market still lower.

Looking for such triggers, University of Texas professor Paul Tetlock tracked the daily “Abreast of the Market” column in the Wall Street Journal, believing the words in the column to be harbingers of what is to come in the market, even when they don’t talk about hard numbers.

Tetlock analysed every column from 1984 to 1999, using a computer to read more than 3,700 editions of the column. He relied on a content analysis program in which psychologists had categorized most of the commonly used words in the English language into one of 77 categories.

After a particularly rough day in the stock market, the column is, not surprisingly, heavy with negative vocabulary. Tetlock documents that a pessimistic column with many words that communicate weakness and negativity not only describes what happened in the previous day’s trading but also foreshadows the next day’s activity.

In other words, as the mood of the column goes, so goes the market. The problem, of course, is that daily papers exist to report daily news, but sound financial planning doesn’t change every day.

The effect was noticeable, however. Tetlock found that a typical increase in the column’s negativity foreshadowed a fall of 0.081 of one percentage point, or 8.1 basis points, in the Dow Jones industrial average the next trading day.

Further support for contrarian analysis comes from a recent Journal of Finance study entitled “Investor Sentiment and the Cross-Section of Stock Returns.” In it, Harvard University professor Malcolm P. Baker and Jeffrey Wurgler, an associate professor of finance at New York University, document their attempt to determine which areas of the market are most influenced by sentiment.

The professors focused on small-cap growth companies because their asset size and frequently inconsistent earnings make them most vulnerable to investor moods. Traditional balance sheet analysis provides relatively little insight into these stocks, so their valuations tend to be more subjective, driven largely by investor enthusiasm.

Looking at 40 years of data going back to 1963, the researchers discovered that small-cap growth stocks in particular perform very poorly after market peaks. That makes sense, because investor enthusiasm would have pushed the prices of these stocks to very high levels, making them vulnerable to even the slightest decline in inves-tor support.

The opposite was true following periods of low sentiment, the professors found. Small-cap growth stocks are often decimated once investors become disheartened, potentially offering significant subsequent returns on the upswing.

And what about larger companies, whose fortunes are generally governed by more traditional balance sheet issues? The researchers found investor sentiment has relatively little effect on these stocks.

But what if sentiment is simply a function of price, asks State University of New York professor Brett Steenbarger. It’s not just that bullish sentiment leads people to put their money into stocks; rising stocks also might generate bullish sentiment, he maintains.

Such a conclusion would fit with previous research that found margin debt slightly lags stock index prices, he says. In other words, people borrow money for investment when they see rising prices.

When investors are bullish in the absence of great strength in new highs, that bullishness is often misplaced, he believes. And that translates into much more modest returns, going forward.

When things are highly bearish and lots of stocks are making new lows, the odds of future gains are clearly in a trader’s favour, he maintains.

How much so? Well, when bullish sentiment has been 10% or more below average, the next 20 weeks see an average 7.3% gain in the Dow — much stronger than the average 20-week Dow gain, Steenbarger’s research suggests. IE