Purifying Stock Market Sentiment Indicators

It is arguable that sentiment indicators derive substantially from what just happened in the stock market and that they therefore add little or no value to price action itself in predicting future returns. In their May 2009 paper entitled “Purified Sentiment Indicators for the Stock Market”, David Aronson and John Wolberg investigate this thesis by removing the influence of recent stock market price dynamics (defined by 18 variations of price velocity, acceleration and volatility) to produce multiple “purified” versions of each of five sentiment indicators: (1) the CBOE Implied Volatility Index (VIX); (2), the CBOE Equity Put-to-Call Ratio (PCR); (3) the American Association of Individual Investors Bulls minus Bears (AAII); (4) the Investors Intelligence Bulls minus and Bears (INV); and, (5) Hulbert’s Stock Newsletter Sentiment Index (HUL). They then measure the power of the purified sentiment indicators to generate profitable trading signals by testing 100 signaling rules for each indicator. Using data for the five sentiment indicators from initial availability (ranging from January 1963 to July 1987) through October 2008, along with contemporaneous daily closes of the S&P 500 index, they conclude that: (more…)