Putting A Bullish Signal In Context

Figure 1 shows the "Dumb Money" indicator. The "dumb money" 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. The indicator has moved to an extreme reading suggesting that retail investors are bearish on the equity markets, and this is a bullish signal.

Figure 1. "Dumb Money"

So what does a bullish signal mean for equity prices? To assess the significance of a bullish signal, I will construct a strategy to buy and hold the S&P500 only during those times when investor sentiment, as measured by the "dumb money" indicator, is bearish (i.e., bull signal). So we "buy" the S&P500 when the "dumb money" indicator turns bearish (i.e., bull signal) and sell the position when the indicator moves to neutral. All signals are based upon weekly closing prices, and slippage and commissions are not considered in the results.

Since August, 1990, there have been 41 unique signals (or trades) when the "dumb money" went bearish. 81% of the trades were winners, and the average trade lasted 6.1 weeks. Such a strategy generated 549 S&P500 points; over the same time period, a buy and hold strategy yielded 348 S&P500 points. With the strategy, your total time in the market would have been 21%. What is noteworthy about this strategy is that for only 1/5th market exposure you beat a buy and hold strategy by a little more than 1.5 times (549 S&P500 points/ 348 S&P500 points). So when this strategy is active and in the market, you are earning a return at a 35% annualized rate. I would call that an accelerated gain.

Applying the same strategy to the NASDAQ 100, yields the following results: 1) there were 41 trades; 2) 78% were profitable; 3) this yielded 1883 NASDAQ 100 points; 4) over the same time period, buy and hold yielded 858 NASDAQ 100 points; 5) with the strategy, your time in the market was 21%. With the strategy and for only 1/5th market exposure, you beat buy and hold by over 2 times. Or when the strategy is active and in the market, you will see your money grow at an 80% annualized rate. Now that is definitely accelerated.

So this is just one of the reasons why I believe that a contrarian approach is worthwhile to pursue. Now remember, we are not crafting a real strategy here; we are only looking at this period when investors (i.e., the "dumb money") are bearish.

But as we all know, there is no free lunch when it comes to the markets, and any discussion of a strategy would not be complete without some mention of the risks involved. This is my way of saying that betting against the consensus is no "holy grail" strategy.

To assess risk and to put a bullish signal into some context, we will look at the MAE graph for the above strategy involving the S&P500. MAE stands for maximum adverse excursion, and each caret in the graph is representative of 1 trade from the strategy. MAE measures in percentage terms how much each trade moves adverse to or against its entry price before it is closed out for a profit or loss.

So let's refer to figure 2 and the individual trade inside the blue box. This trade was put on and lost 7% (x axis) before being closed out for an 8.5% profit (y axis). We know that it is a profitable trade because the caret is green. Now focus to the right of the blue vertical line. There were 6 trades (out of 41) that had excessive MAE's that resulted in significant losses. There is real risk even when betting against the consensus. Of note, the signal labeled #1 was from May to August, 2002; the signal labeled #2 was September to November, 2008.

Figure 2. MAE Graph/ SP500

The MAE graph for the NASDAQ 100 trade is shown in figure 3. Of the 41 trades, 9 had MAE's in excess of 10%; this is to the right of the blue line.

Figure 3. MAE Graph/ NASDAQ 100

So let's summarize to this point. Betting against the consensus can yield significant gains with minimal market exposure. As the MAE graphs show, risks still remain.

Now the question becomes: how do we continue to maximize our gains while minimizing our risks? To look at this question, we will construct another strategy where we buy the S&P500 after two consecutive weeks of the "dumb money" being bearish; we will sell our position, as before, when the "dumb money" indicator turns neutral. With this strategy, there are 37 trades. 78% are profitable yielding 626 S&P500 points. Our time in the market is now reduced to 17%. So just by waiting a week to "buy", we increase our points gained (by ~15%) and decrease our time in the market.

Furthermore, the MAE graph (see figure 4, below) now clearly shows that any trade that had a draw down greater than 6% from its entry price ended up being a loser or closed out for a small gain. These are the trades to the right of the blue line. This suggests to me that any trade in the S&P500 that incurs a loss greater than 6% will likely not recover and lead to further losses. In other words, this is a failed signal.

Figure 4. MAE Graph/ SP500

Applying the same strategy to the NASDAQ 100, yields the following results: 1) there were 37 trades; 2) 73% were profitable; 3) the strategy now yields 2206 NASDAQ 100 points; 4) your market exposure is reduced to 17%. More points with less exposure equates to more efficient market timing. The MAE graph is shown in figure 5.

Figure 5. MAE Graph/ NASDAQ 100

So what does it all mean?

1) To beat the market, you cannot be the market. Therefore, bet against the consensus.

2) Like all strategies, there are failures.

3) When the "dumb money" indicator turns bearish, the optimal -not the best - time to act is after two weeks. Gains can be improved and risks reduced (but not eliminated). Using stop losses, hedging strategies, or entries based upon other technical markers (i.e, a close greater than the previous week's high) may improve the efficiency of this strategy.

4) I hope I have demonstrated the importance of paying attention to extreme investor sentiment.