In the comments section of one of my posts, reader Phil wrote: “Guy, I love your stuff. Question though. We had a minor correction before it was off to the races after QE2. What makes you think sentiment will be a tie breaker this time? Couldn’t we just as easily head higher into a Fed engineered speculative blow off (2000 style)? I mean, it’s happened before (:”. Let me respond.
First, my thanks for the compliment; it is always nice to get a pat on the back once in a while.
Second, let me make several observations about what I do and how I put it all together to arrive at a final trading decision. In a general sense, I try to determine those factors that lead to sustainable price moves, and if I believe that an asset has the potential for a sustainable price move, then I will direct my capital towards that asset to a greater degree. When it comes to equities, I use multiple factors to determine those best times. Some of those factors that I actively include in my models are many of the same things that I write about on this blog and these include: investor sentiment, inflation pressures, technical analysis of prices, and whether the economy is in recession or not. I am also intrigued by cyclical earnings and intermarket analysis; in particular, I am always looking for new ways to look at price movements. When you put all this “stuff” together it results in several models that help me navigate the markets.
Are the models perfect? Absolutely not, and they are not designed to catch every wiggle in the markets. The factors I use have been back tested and seem to have the greatest influence on prices in the intermediate term. I like using investor sentiment because it gives me the discipline to buy low and sell high. I spend a lot on time technical analysis because the fundamentals don’t always predict the direction of prices. You need to have a safety factor built in to the models to know when you are wrong, and technical analysis is that safety factor. So when I put it all together, my models are more than just sentiment based, and if I am wrong, then the models will pick that up and make that adjustment.
So my “call” for a market top is based not only on investor sentiment but other factors. I also recognize that I can be wrong, but over the history of my data set, I am looking at the average outcome of factors, and I do not expect that this time will be different. Could we get that little blow off top that reader Phil mentions? Absolutely. But from this perspective it would be the outlier and not the expected outcome based upon the current market environment as I have defined it.
But let’s get a bit more specific and look at QE2 and investor sentiment during that time period as compared to now. See figure 1 a weekly chart of the SP500 with the ratio of all the assets in the Rydex Bull Funds to the Bear Funds in the lower panel. As reader Phil mentioned, QE2 (November, 2010) produced a “pop” upon its implementation and pulled back for several weeks after the initial euphoria. This is shown inside the gray oval on the price chart. QE3 appears to be doing the same thing — “pop” 4 weeks ago and pullback. While I don’t have a crystal ball to tell me if prices are going higher, the sentiment picture is completely different in November, 2010 as opposed to now. In November, 2010, the Rydex indicator in the chart had a value of 56% and was headed higher in a sign that money was coming into the market. Currently, the indicator is rolling over (as money is leaving the market) and it is doing it at a level that was seen at the market tops in 2010, 2011, and 2012. So from this one perspective or snap shot of investor sentiment (via the Rydex data), QE3 is facing much greater headwinds than QE2.
Figure 1. SP500/ weekly
If I am wrong, how will I know? As investor sentiment often tracks prices (until it doesn’t), higher prices will likely be accompanied by increasing number of bulls. It takes bulls to make a bull market, and prices won’t go up without an expansion in the number of bulls. Buyers have to surface or prices will fall. At present, we are not seeing that kind of price action.
So in summary, multiple “points of light” go into the models. The models help me navigate the markets and shed light where we are on the playing field.