Sunday, April 12, 2009

Investor Sentiment: Looking For A Top

This is now the fourth week in a row where investor sentiment, as measured by the "Dumb Money" indicator, remains neutral. When we couple this with the fact that prices on the major stock indices remain below their 40 week moving averages, there is a high likelihood that the market will rollover in the next several weeks. I have previously discussed these observations in the article, "Investor Sentiment: Some Context".

The "Dumb Money" indicator is shown in figure 1, and it is in the neutral zone. 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.

Figure 1. "Dumb Money" Indicator/ weekly

The bear market rally that started 5 weeks ago will likely stall over the next couple of weeks just as more investors are drawn into the market for fear of missing the "big one". Why should the cycle of fear and greed be any different this time? While it does take bulls to make a bull market, there are several additional technical insights that suggest that this rally will fail:

1) with the exception of the NASDAQ, which has been our relative leader, prices on the other major indices (i.e., DJIA, S&P500, Russell 2000) have only retraced back to the point where they broke down in early February;

2) measures of market breadth, such as the McClellan Oscillator and cumulative volume, are beginning to negatively diverge from price, and this suggests waning upside momentum.

3) another breadth measure is the percentage of NYSE stocks trading above their 40 day moving average; this is an indicator found in the popular TeleChart software package developed by the Worden Brothers; the "T2108" indicator is shown in figure 2, and the current value is close to 90% -meaning that 90% of NYSE stocks are trading above their 40 day moving average. Within the context of a bear market or down sloping 40 week moving average, this is an extreme, overbought number that has typically signaled an intermediate term top. Past occurrences are noted with the maroon colored vertical bars in figure 2.

Figure 2. % NYSE Stocks Above 40 Day MA/ weekly

Lastly, for completeness sake, I have included the "Smart Money" indicator in figure 3. 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. The "smart money" remains neutral and this is surprising considering the 20 plus percent run in the major indices over the past 4 weeks.

Figure 3. "Smart Money" Indicator/ weekly


biscosc said...

Hello Guy, I'd like to thank you for your continued excellent posts! I did have a question about your entry and exit rules. I know you like to enter after 2 consecutive weeks of "dumb money" having bearish sentiment when price is below the 40-week moving average. Does this entry differ when prices are above the 40-week moving average? Also, do the exits change at all based on the position of current price above or below the 40-week MA?

Guy M. Lerner said...


Thanks for the compliments!

The optimal time to take an entry is 2 consecutive weeks of the "dumb money" being bearish; this is correct; it always isn't the best time as the recent up cycle demonstrates; I think the S&P500 jumped about 8% that first week when sentiment was bearish.

Therefore, I tend to view these swings in sentiment as to where I want to be in a week or two down the road, and if you notice from my commentary, I try to present it to you, the reader, in this fashion. For example, with sentiment remaining neutral for 5 weeks in a row (at the end of the present week) and prices below the 200 d ma, we know that something should happen over the next couple of weeks. It is unlikely that the ascent of prices will be what they were over the last 5 weeks and there is a high probability of this rally rolling over. The idea of the indicators isn't to present an exact timing signal but a market environment of how we want to position ourselves.

Having said that I have given entries and exits a lot of thought when we are in these zones where we expect trends to change. I will share with you the 3 entries and exits that I use to get in and out of positions.

I base my entries and exits on 3 things that I call: time, pick a point, and descretion.

An example of a time entry would be taking a 1/3 position exactly when the "dumb money" is bearish two weeks in a row. No quetions asked - just jump in.

An example of a pick a point entry (exit)is to do something when price hits a certain point or level. I anticipate selling a third of my QQQQ position when and if prices tag the 40 week moving average.

An example of a descretionary entry (exit) would be to draw a trend line from the highs and take a position on a close over that trend line.

With regards to the entries, there are no other filters; I use to use filters (i.e., breadth) but found it to be too many rules, so I just take it as 2 consecutive weeks of the dumb money being bearish; now I can tell you that there are better places than others when sentiment works and this has to be with where the sentiment turns bearish relative to other pivot point lows. But we will save that for the next bull market.

Exits and sentiment depend upon two things: 1) if sentiment is neutral for 5 weeks in a row and prices are under the 40 wk MA, then you look to sell; this will be our current situation at the end of this week; 2) if sentiment becomes excessively bullish and prices are above the 40 wk MA then you wait for sentiment to become less bullish and the dumb money will turn neutral; my research shows once you get that signal you are best selling into any price spike or a week where the c>o.

John Hussman has an excellent discussion of the 200 day moving average on his website this week.

biscosc said...

Thanks for your reply!

I like your method of giving tops during bull markets more time to form by waiting for sentiment to go neutral from bullish. Did this add considerable edge over just selling when sentiment went bullish?

Guy M. Lerner said...

Market tops are a process -drawn out.

Market bottoms are an event - one day affairs.