The Inflation Indicator Meets The "Dumb Money" Indicator

I thought it would be interesting to combine my inflation indicator, which is derived from the trends in gold, crude oil and yields on the 10 year Treasury, with the "Dumb Money" indicator, which is derived from widely available investor sentiment data.

Both indicators are now in that extreme zone, and I recently reviewed each indicator over the past week. The inflation indicator is in that extreme zone that should be a headwind for equities, and the "Dumb Money" indicator has been in the excessive bullish zone (i.e. bear signal) for 3 months now . Alone, each should produce headwinds for equities but what happens when there is a confluence of these two extremes - one detecting strong trends in gold, crude oil, and yields on the 10 year Treasury and the other detecting excessive and bullish investor sentiment?

Figure 1 is a weekly chart of the S&P500. The red dots over the price bars indicate when both the inflation indicator and the "Dumb Money" indicator are in the extreme zone at the same time. I have labeled each occurrence with the date. The two instances in the current rally were associated with the only meaningful pullbacks since March, 2009. The other three instances on this chart were associated with the run up to the 2007 bull market top.

Figure 1. S&P500/ weekly

Figure 2 shows those occurrences from 2003 to 2006. There were multiple dots that occurred throughout the bull run of 2003. For the most part, the bulls won out as this was one of those circumstances where it took bulls to make a bull market. But if you look closely, the dots at 7/25/03 and 10/10/03 did result in a trading range. Only the 12/12/03 signal resulted in a bull market blow off that was retraced over the next 3 to 4 months.

Figure 2. S&P500/ weekly

Figure 3 is from 1999 to 2003. The 1999 signal led up to the market top in 2000, and the bear market signals in 2001 and 2002 marked the highs that led to significant down legs. (Hindsight is 20/20!!!)

Figure 3. S&P500/ weekly

For the rest of the 1990's, there was only one other signal (not shown) and this was on 2/23/96, and this led to a 5 month trading range - the first real consolidation since the January, 1995 lows.

In the last 2 weeks, I have included the following words in my weekly articles on sentiment: "There is probably greater risk of a market down draft now than in past weeks." This past week I even underlined those words for emphasis. So why did I do that? When looking at these signals, it is clear to me that prior occurrences were associated with some fairly nasty 1 week sell offs, and I am not really considering those intermediate bear market highs from 2001 to 2002.

In a market driven by Dollar devaluation and "liquidity" this is what I would expect: there will be sudden down drafts that should be scooped up rather quickly as long as investor sentiment remains as bullish as it has been.