Swimming against the tide is not always prudent. Technicians accept the existence and benefits of learning from the "inside" knowledge of smart, sophisticated investors.
Technical analysts are not only the practitioners of the contrary-opinion rules, but they also believe that smart and sophisticated investors have something of value to offer, too. And that could potentially be quite a “something.”
Confidence Index
The Confidence Index is published by Barron’s, and it is a ratio that indicates the spread between average yields of Barron’s ten highest-grade corporate bonds and average yields of 40 Dow Jones bonds.
The notion is that yields of Barron’s high grade bonds are expected to be lower than yields in the larger cross-section of Dow Jones bonds. So, when the Confidence Index nears 100, the spread between the two sets of bonds tends to get narrower and narrower. (Note that narrower spreads mean good news, while wider spreads indicate the presence of higher risk levels, particularly default, credit and reinvestment risks).
Technical analysts believe that the Confidence Index ratio is particularly bullish when coinciding with periods of increased bullish sentiment in the market, as investors are generally more willing to risk investing in lower-grade bonds in exchange for higher yields. Of course, such market action brings down average yields for the larger cross section of bonds, resulting in the Confidence Index increasing.
The opposite happens when investors are pessimistic. When bearish sentiment dominates, investors typically avoid low-grade bonds, which results in widening the yield spread between Barron’s high-grade bonds and 40 Dow Jones bonds, thus pushing the Confidence Index down.
However, the problem with this relatively simplistic interpretation of the Confidence Index is the technicians’ perceptions of yield changes as almost exclusively caused by shifts in investor sentiment. What this interpretation fails to take into consideration are changes in the supply of certain grades of bonds, which can also have both adverse and positive impacts on yield spreads, thus causing the Confidence Index either to increase or decrease. If the underlying reason for changes in yield spreads are changes in the supply/demand relationships, then it is quite possible that the Confidence Index could generate false signals.
T-Bill vs. Eurodollar Yield Spread
Another popular measure of investor sentiment is the yield spread between T-Bills and Eurodollar yields, especially since this particular spread is generally indicative of the global confidence levels.
For example, when global markets appear to be caught in international financial turmoils, such is the recent example of credit crisis spilling over from the U.S. into international credit markets, the spread between T-Bill yields and rates on Eurodollar rates widens. What this means is that the smart money flows from riskier securities to safe-haven Treasuries, effectively decreasing the ratio. Furthermore, empirical data has shown that, as the spread widens, stock markets shortly after experience a trough.
Margin Debt
Margin debt held in brokerage accounts is also highly indicative of what the “smart money” thinks about current market conditions. Increased margin debt suggests that when sophisticated investors are bullish, they do not cringe away from buying securities with any capital they can get their hands on, even with borrowed money.
In contrast, when margin debt levels decline, it usually means that knowledgeable investors are reluctant to use leverage for investments and are more likely to become lenders than borrowers, which is considered a bearish signal.
Note that monthly margin debt stats are published in Barron’s. However, this report excludes debt balances reported by sources other than brokerage accounts, such as banks, credit unions, etc.
(This article is part of a series. Access the next article in the series by following this link.)
Sources: Investment Analysis and Portfolio Management, Eighth Edition, by Frank K. Reilly and Keith C. Brown, 2005
Optional reading: Chart School at www.stockcharts.com
