Interview with Jason Goepfert | Option Alpha Podcast

On this week's podcast, we finally release our much-anticipated interview with Jason Goepfert of SentimenTrader.com.

Jason and I dive deep into investor psychology and market sentiment analysis. We discuss the concept of managing risk exposure and if using sentiment, as opposed to market timing, actually works.

Irrational Behavior

We don't always do the most rational thing with our investments and trades. This is why sentiment analysis is so important.

While working at Wells Fargo, Jason took hundreds of daily calls from customers. Initially, Jason believed people behave rationally. But after speaking to so many people, he realized many financial decisions are not made rationally.

"If you ever want a lesson in irrational behavior, you should listen to a margin call."

The experience told him a lot about what might be driving stocks.

Momentum vs. Sentiment

Does price reflect future expectations or what’s already happened? Jason believes many people follow the herd, which impacts the market, so sentiment plays a key role in an asset’s price.

Jason contends that technicians assume there's no point in looking at the fundamentals, sentiment, or people's attitudes because everything is reflected in the current price. (Also known as the Efficient Market Hypothesis).

However, 2008 is a classic example that not everything can be factored into a security’s price. So Jason concedes that his approach is not right 100% of the time.

Therefore, Jason looks at momentum as much as sentiment to evaluate the market.

Dumb Money vs. Smart Money

"Dumb money" is typically trend-following investors. However, dumb money is right most of the time. Jason uses the term simply because that group of traders tends to be over-allocated when risk is highest.

When stocks peak, dumb money tends to have large long positions. And when stocks bottom, they have the largest short positions. Once sentiment turns, the dumb money is right and smart money is wrong. So, most of his indicators typically track trend-following traders.

Smart money indicators are generally the opposite. "Smart money" buys when stocks are falling. They're wrong as the market is trending. These traders tend to be net long as the market bottoms; when stocks peak, they have the largest short positions.

This behavior is contrarian and rejects the notion that we operate in emotionless markets, even with computers.

Commitments of Traders

The Commitments of Traders (COT) report is published weekly and breaks down positions in various futures and futures options markets.

The COT report, however, is not a buy or sell signal in and of itself. As Kirk mentions, the institutional traders may be net short despite massive buying for an extended time period.

If you just look at things in a vacuum and think, “If institutions are short, then I should be short,” you could be dramatically wrong. Markets are too nuanced. Taking large positions based on one signal is not advised because the COT is just one indicator.

You must use market context to determine how much weight to put on each indicator. Things change. Pay attention to context. Don't assume an indicator will work a certain way, just because that's what you were told, or read, or how it performed in the past.

How Should You Use Sentiment?

Jason suggests simply doing a Google search on sentiment. There's also quite a bit of data available to monitor current sentiment. For example, the CNN fear and greed index gives a good sense of how sentiment moves with the market.

Sentiment is mostly based on price. When prices go up, people feel more optimistic, and vice versa.

Jason focuses on extremes. When things are overly optimistic, future returns are typically lower, and vice versa.

Approach

Jason looks objectively at four main factors when entering and exiting positions:

Average return over different time frames
The percentage of time the security was higher or lower
The probability of success
The maximum risk vs. reward

Models

SentimenTrader publishes different models, but Jason’s favorite is Money Confidence because it fits the “sweet spot” time frame of a lot of their indicators.

Listener Questions:

What's a warning sign that this rally we’re in is over?
The Fed is buying, so how can you fight that?
Are there any models Jason thinks are broken?

Trader Q&A:

“NORM: Hi, Kirk. My name’s Norm. I’m from Saginaw. I've been value investing for about 20 years. Just recently started options trading, because I finally have an IRA that's about $150k. I quit working about 10 years ago to be a stay-at-home dad. My wife continues to work. She has a good job. She just recently inherited about a $200k IRA, and I'm going to trade that. She also has a very large IRA, just under seven figures now. After listening to Episode 143, ‘What's the Rationale Behind Entering New Trades,’ I really liked the podcast and how you've set that all up. My question really relates to how to trade a large account, as far as diversifying it and, perhaps, breaking it into smaller trades, smaller trade amounts, or smaller account amounts, and then trading each of those separately. I was wondering if you could expand on that. Separate question was, would you consider adding the S&P 500 comparison to your portfolio on your performance page? Thanks so much for all you do. Really appreciate it. Amazed at how much you do for everyone, and how little credit you get, but it's not missed. Thanks so much.”