Saturday, August 8, 2009

Investor Sentiment: Extremely Extreme

Investor sentiment is extremely bullish as the "Dumb Money" indicator has registered its second most extreme reading ever. The current value is only less than the value seen in May, 2003, which was at the start of the last bull market.

The "Dumb Money" indicator is shown in figure 1. The "Dumb Money" indicator 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

I would apply 3 interpretations or scenarios to the current extreme readings in investor sentiment:

1) This is a bull market, and as we know, it takes bulls to make a bull market. Extremes in investor sentiment - just like over bought signals - are irrelevant.

2) Even though prices may be higher over time, the market is likely to consolidate (i.e., trade in a range) over the next couple of weeks; referring back to figure 1 and the 2003 time period, we note that the market actually went sideways for about 13 weeks following the extremely extreme extremes in investor sentiment. I suspect that this will be the most likely scenario for now. There will be a bid under the market. It will be tough to short or bet against this market for the foreseeable future.

3) The last scenario is that the current extremes in investor sentiment will mark the price highs in the major indices leading to the mother of all fake outs. This scenario is still very much on the table, but with an expected bid below the market, I don't see the market making a sudden reversal anytime soon. Market tops are a drawn out affair!

In sum, the bulls remain in control, and despite the bullish extremes in investor sentiment, it will likely be some time before the market rolls over. There may be a lot of believers, and in general, this is not good for higher prices, but these buyers won't give up so easily. As I am not one to chase prices higher, I would still wait for a more risk adjusted entry.

The "Smart Money" indicator is shown in figure 2. 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" is neutral.

Figure 2. "Smart Money" Indicator/ weekly

16 comments:

Anonymous said...

seems like dumb money is not so dumb and smart money is not so smart anymore

Guy M. Lerner said...

It happens from time to time, but over the course of time prices and investors will follow usual patterns; you could have easily picked on the PE ratio and suggested why follow valuations. Plus from an efficiency perspective - that is for time in the market, equity curve drawdown, and gains - betting against the crowd is probably the most rewarding strategy; sometimes you get in too early and sometimes you get out too early but overall it is the best strategy that I have found

Anonymous said...

yea, i was betting against the crowd since April and it did not work out so well for me...

Anonymous said...

Somehow I feel you yourself have become swept up in the euphoric blindness of the market. Good luck on the 'long' side as the system continues to deteriorate.

Guy M. Lerner said...

Anonymous:

I don't mean to be smart, funny, coy or to minimalize or trivialize that I have been wrong with regards to equities about the last 15% or so, but the sentiment data is the sentiment data; I don't make the data and I don't fudge it either; I just present it.

The dumb money indicator has not changed in over 5 years, and it has been used real time through 2 bear markets now; it has pitfalls and I am very careful to explain those.....I don't pretend nor do I ever try to represent that I have some sort of holy grail; I am not running a trading service but I feel compelled that if I am going to present something to the readers then I should provide some context to what I am writing about.

As far as being swept up in the euphoria, I do what I say and write about; so for starters, I have been long Treasury yields (for months) and long those things that would benefit from a falling dollar; I have been long Japan;I have about 10 points in GLD; I am not suffering nor am I in a panic; if I get an opportunity for an entry into an equity index, then I will take it; the position will be risk adjusted for actual percentage loss plus it will be risk adjusted or sized relative to other holdings in my portfolio.

I really feel that the Faber system plus a filter for inflation really has merit, and I expressed this in several different articles starting about 4 weeks ago so I am not sure "euphoria" is quite the right term here as I have been percolating this trade for several weeks now; plus even if I still feel that this is not a proper launching pad to a new bull market, I will take my risk adjusted chance. None of us know the future and where prices will be tomorrow, next week or next month. But I do know where I will admit defeat on this trade. This much I have in my control.

tv said...

For your bid under the market scenario, you use 2003 as support of your thesis.

I wonder how a larger sample size -other than one - effects your thesis.

Guy M. Lerner said...

TV Said:

There were 2 other extreme readings of the indicator that did not exceed the current value but were close; they would be 3 and 4 of the most extreme readings; the first was 2/22/91 and the second was 6/20/97; in both instances the market (sp500) traded in a range for 13 or more weeks essentially allowing the 40 week ma to catch up with prices

Anonymous said...

Could you please post what the smart money indicators looked like back in 2003?? Thanks!

doiknowwhat said...

thanks a lot for this webpage, it's extremely helpful!

if there's anyone criticizing you for making the information public with possible interpretations, that's ridiculous!

so the smart money is neutral - thank you very much; sounds like shorting it at the top of the upward trend channel could still be the money shot, without risking too much. That makes sense as the smart money has to take $ from the dumb money at all times...

System manager said...

A good measure of broad market strength that will last for months is to look at the % of stocks above their 50 MA . When this turns up above 86 on a weekly close (after a significant decline, then the rally will continue. http://www2.barchart.com/momentum.asp
Signal date was 4/18/09 and previous was 5/9/03 ....

Guy M. Lerner said...

system manager: I do follow this metric as well; currently the value is high but not as high as the initial thrust off the March bottom

Anonymous: I will post smart money and dumb money charts tonite or tomorrow and folks can compare the indicators and time period as well

Anonymous said...

Just looking at the chart, these indicators dont seem to be relevant for any medium term view. Perhaps for the immediate short term, but even there the hit rate seems poor

Guy M. Lerner said...

Anonymous: Here is a link that should put the buy signals in context and why monitoring sentiment is so important; after reading the article,if you have questions please feel free to ask.

I haven't read the article in awhile but I am sure that I have provided information on 1) why we should bet against the crowd; 2) expected draw downs and losses; 3) time in the market; 4) optimal buy signals and a whole bunch of other information that any good trader would want to know.

Once again, read the article to get an idea if this is for you and the chosen time frame you work on; some folks think that taking a 2% loss to their portfolio is too much; I cannot thread the needle in such a manner.

Here is the link: "Putting A Bullish Signal In Context"

Anonymous said...

Thanks guy for update. Question: I have historical AAI and Investor Sentiment data. What would be a good place to start in backtesting? For example, when % Bulls is under x%, and vice versa?

So far, the results aren't that great, but it could very well be the parameters I'm using. Thanks again! - Steve

Guy M. Lerner said...

Steve

I try to keep things simple; look at a simple ratio and then wrap the value in trading bands looking for extremes in the data over the past year

some people do things like take the interest rate environment that we are in, etc

Anonymous said...

I wouldn't say the dumb money was wrong at the previous extreme in
April-May 2003. The Dow and the SPX were in an uptrend that continued without any serious correction through February 2004.

April-May 2003 was a good time to buy and hold (for at least the next 3 quarters and really until October 2007).