Investor Sentiment: Pray for Bearish Extremes
Investor sentiment hit a bullish extreme when the Federal Reserve announced QE3 7 weeks ago. Oops! Since then the equity market has done nothing but rollover and as expected, so has investor sentiment. Investors usually sour on the markets when prices head lower. Investor sentiment is cyclical as bearish extremes (bull signals) will follow bullish extremes (bear signals) and so on. The markets are headed towards extremes in bearish sentiment, which means we should expect lower prices. It would be nice to see investor sentiment turn really bearish before stocks bottom and pivot higher. This should be several weeks away. Anything short of this will lead to a sub-optimal bounce. As investors are finding out after each QE, a market that fails to clear itself of the weak hands is a market built upon a poor foundation. So if you want to be a bull, you should pray for lower prices and bearish extremes.
The “Dumb Money” indicator (see figure 1) looks for extremes in the data from 4 different groups of investors who historically have been wrong on the market: 1) Investors Intelligence; 2) MarketVane; 3) American Association of Individual Investors; and 4) the put call ratio. This indicator is neutral, and just below the extremely bullish level. Bullish sentiment is unwinding.
Figure 1. “Dumb Money”/ weekly
Figure 2 is a weekly chart of the SP500 with the InsiderScore “entire market” value in the lower panel. From the InsiderScore weekly report: “Insider trading volume is seasonally light across the market as most companies have closed trading windows, effectively prohibiting insiders from buying or selling until after the release of Q3’12 earnings. Transactional volume, however, will begin to increase over the next few days as earnings season hits its stride. This past week, sellers outnumbered buyers by a 7:4 margin market-wide and the top-line sectors showed Neutral sentiment readings.”
Figure 2. InsiderScore “Entire Market” value/ weekly
Figure 3 is a weekly chart of the SP500. The indicator in the lower panel measures all the assets in the Rydex bullish oriented equity funds divided by the sum of assets in the bullish oriented equity funds plus the assets in the bearish oriented equity funds. When the indicator is green, the value is low and there is fear in the market; this is where market bottoms are forged. When the indicator is red, there is complacency in the market. There are too many bulls and this is when market advances stall. Currently, the value of the indicator is 69.83%. Values less than 50% are associated with market bottoms. Values greater than 58% are associated with market tops. It should be noted that the market topped out in 2011 with this indicator between 70% and 72%.
Figure 3. Rydex Total Bull v. Total Bear/ weekly
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Category: Market Sentiment
Hi Guy,
Certainly at some point the market will see bearish extremes (it always does), but what would imply that we would not work off some bullish sentiment and simply head back to bullish extremes again? I mean, my own analysis suggests the market is overpriced just by looking at the continued upward momentum in price through QE3 overlaid against corporate results (showing declining earnings momentum on aggregate, and more telling, problems at the top line for an expected 2 quarters minimally). So, I’m looking at rate of change, and it looks high risk to me at these levels, but I’m simply curious what past data you have that suggests we’re on our way to the opposite sentiment extreme.
Thank you, as always, great analysis.
Hi Phil:
Good question…
1) sentiment is cyclical ….bear extremes follow bull extremes and so on
2) while I cannot know exactly/ perfectly that we will get to that bearish extreme, I can state that for the most part (meaning not always but > 80% of the time), bounces that occur before bearish extremes are made tend to be poor
3) this does not imply that every bearish extreme will result in a bounce that is playable and sustainable, but failure to bounce when sentiment is bearish (bull signal) generally is a poor sign
4) it would be very unlikely (although once again possible but not highly probable) for the bulls to re-assert themselves at this late stage in the cycle; the phenomena of too many leading to higher prices is something you see in the beginning of the cycle
I hope that answers it; we want certainty and logic, but the market gives us anything but that. I try to put a structure to it by being quantitative in my approach.
It makes sense to me in light of corporate results and the backdrop of cyclically high consumer confidence and use of revolving credit (against the backdrop of declining real houshold incomes due largely to reduced participation in the labor force). The fundamental data suggests consolidation at best, and since the market has largely moved on earnings growth momentum, I’m not sure how far we eventually go on a stall or reversal. But, I believe you are wise in your assertion to stay clear without an extreme in bearish sentiment, however long that takes.
Phil:
Whether right or wrong, I try to look at the market from as many angles as possible….although I don’t use the variables you mention, I am sure they would probably show the same thing but maybe with a longer time frame
Also, using so much data gets into analysis paralysis I think – at some point I got to pull the trigger
One other thing I try to do with analysis (especially the technical stuff) is apply the same thing across multiple assets and time frames
Lastly, I appreciate your discourse in these comments