Saturday, January 10, 2009

Investor Sentiment: Sell Strength (Again!)

Investor Sentiment: January 12, 2009

The "dumb money" and "smart money" sentiment indicators are neutral on the equity markets. While a neutral reading is not particularly telling regarding market direction, it should be noted that this is the fifth week in a row where the "dumb money" is neutral, and this is not a scenario that is generally supportive of higher prices especially with prices on the S&P500 under their 40 week moving average. The ideal situation for higher equity prices would be for the "smart money" to be bullish and the "dumb money" bearish (i.e., bull signal).

The "dumb money" or investment sentiment composite indicator (see figure 1, a weekly chart of the S&P500) looks for extremes in the data from 4 different groups of investors who historically have been wrong on the market: 1) Investor Intelligence; 2) Market Vane; 3) American Association of Individual Investors; and 4) the put call ratio.

Figure 1. "Dumb Money"
The "smart money" (see figure 2) refers to those investors and traders who make their living in the markets. Supposedly they are in the know, and we should follow their every move. The "smart money" indicator is a composite of the following data: 1) public to specialist short ratio; 2) specialist short to total short ratio; 3) SP100 option traders.

Figure 2. "Smart Money"


Hope for a better 2009 seen at the start of the year led to selling pressure last week putting the equity markets slightly in the red for the year. With neutral sentiment readings, we can no longer consider sentiment a factor in propelling prices higher, and because we have had 5 consecutive readings with the "dumb money" being neutral and with prices on the S&P500 below their 40 week moving, I have suggested that selling strength was the best course of action for those with a trading mindset. I define what I mean by "strength" in the article, "Investor Sentiment: Some Context".

Without sentiment playing a role, I like to think that stocks now must move higher on their own investment merit. They must prove themselves. What is going to be that catalyst? Another bailout program? Unlikely. Earnings? Unlikely. Better economic fundamentals? Unlikely. The only catalysts that come to mind are the hope for a second half recovery and the hope of an Obama presidency. No doubt both are compelling, but they are only hope. As I stated last week, this a bear market, and the strategy that has worked the best is sell hope, buy fear.

So what's next? Looking ahead it is unlikely that I will be bullish on equities for a multi week trade until the "dumb money" turns bearish (i.e., bull signal). And there are only two ways to bring out more bears. We either have lower prices or a protracted trading range that wears out investors.

5 comments:

Biscosc said...

Do you go long in bear markets? In bear markets I prefer to sell hope and cover fear.

Guy M. Lerner said...

Yes, counter trend rallies are very productive from the long side particularly in bear markets; by my measures this is a bear market and we should be many months away from a real bull

Anonymous said...

can not make any sense of your dumb/smart money sentiment graphs, it looks like there were instance in the past where market went substantially higher when dumb money was in neutral (i assume above 0). Can you explain the graphs little bit and also provide some historical perspective from your own graqphs on how it worked in the past?

Guy M. Lerner said...

Would be happy to...look at figure 1, which is the "dumb money"; when the "dumb money" is bearish this is a bull signal and the graph is green; blue is neutral; red means there are too many bulls and this is a bear signal.

With regards to the "smart money", we want to be bullish when they are bullish; green is a bull signal and blue is neutral and red is bearish.

If you did nothing else but be invested in the market only during those times when the "dumb money" is bearish (i.e., bull signal, green line) you would have easily outperformed the SP500; during these times you can see gains accelerate (money on the sidelines) and gains can occur at a 50% plus annualized clip; does this happen all the time? Absolutely not. About 15% of the time since 1990, the bull signals have led to some uncomfortable drawdowns(>8% on the SP500); the point: you still have to use stops or some sort of methodology to get you out if you are wrong because they don't ring a bell to tell you it isn't working this time.

Now as far as a neutral reading (i.e., blue line), all I stated was that 5 consecutive weekly readings with price still under the 200 d ma is likely bearish; we no longer have excessive bearish sentiment amongst the "dumb money" ( a bull signal) to drive prices higher. Prices go higher all the time when the line is blue but those prices tend to be above the 200 d ma already.

Prices can go much higher when the "dumb money" indicator is red (bear signal) because it often takes many bulls to make a bull market. But this is the time to be on the look out for divergences between price and other data --ie.., slowing upside momentum.

Lastly, this data extends back to 1990; sentiment data has been very effective since 1982; however, from 1969 to 1982 it wasn't so good. I often wonder is sentiment data just a very good bull market indicator? Or is there truth to the saying that to beat the market you cannot be the market so it is best to bet against the consensus?

Anonymous said...

thanks for your comments on explaining dumb/smat money graphs