Sunday, June 6, 2010

Investor Sentiment: The Sweet Spot

As hard as it is to believe, last week's "fat pitch" is this week's "sweet spot". As expected after last week's gyrations, investor sentiment remains decidedly bearish, and this is a bullish signal as gains can be made at an accelerated pace IF the market turns around. This remains a big "IF". Yet as the data shows, the highest probability for a market turn around is in the second week of extreme bearish sentiment. We are now in that "sweet spot".

Judging by the emails I receive, it seems to be hard for investors to grasp the idea that I view the current market environment as a "fat pitch". If we use the analogy of a card counter in black jack, I can only determine when I bet aggressively. I cannot guarantee that I will get a winning hand even though the cards should be in my favor. Nonetheless, I would always prefer to bet when the chance for strong gains is likely. This is just one aspect of the "fat pitch". The other aspect and it may be more important than all those potential gains is that a failed signal tends to portend a poor outcome for the markets. Based upon my data, I have clearly defined risk parameters, and this is what is so good about the "fat pitch" --possibility for strong gains plus the ability to define my risk. I will take this chance every time. As a reminder, it was only 12 short weeks ago that most investors thought we were entering an investing nirvana - another sure thing. I viewed that market in an opposite light -- possibility for significant losses without the ability to control my risk.

As we all know there is very little good news here or abroad, and with market volatility picking up, investors have a right to be worried. However, as we have seen time and again, the majority of investors are wrong much of the time. We are now entering the sweet spot where we shall see if they are wrong or right. If the majority of investors are right and if the market continues lower despite the bearish sentiment, then there is a strong possibility of deep and extended losses as buyers did not appear when they should have. From this perspective, little has been decided, and with the NASDAQ 100 and Russell 2000 still above their simple 40 week moving averages, it doesn't seem right to throw in the towel. I like my chances here.

The "Dumb Money" indicator (see figure 1) 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 "Dumb Money" indicator is bearish and this is a bullish signal. This is the first bullish signal since March 8, 2009.

Figure 1. "Dumb Money"/ weekly

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" indicator is neutral.

Figure 2. "Smart Money"/weekly

Figure 3 is a weekly chart of the S&P500 with the InsiderScore "entire market" value in the lower panel. From the InsiderScore weekly report we get the following: "This past week was really all about a lack of conviction on both sides of the trade. Buyers were cautious and sellers weren't looking for huge pay days."

Figure 3. InsiderScore "Entire Market" Value/ weekly

Figure 4 is a weekly chart of the S&P500. The indicator in the lower panel measures all the assets in the Rydex bullish oriented equity funds divided by the sum of assets in the bullish oriented equity funds plus the assets in the bearish oriented equity funds. When the indicator is green, the value is low and there is fear in the market; this is where market bottoms are forged. When the indicator is red, there is complacency in the market. There are too many bulls and this is when market advances stall.

Currently, the value of the indicator is 47.56%. Values less than 50% are associated with market bottoms.

Figure 4. Rydex Total Bull v. Total Bear/ weekly

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ryanmburke19 said...


I agree with you that we are in fat pitch zone. Moreover, there are some notable inter-market divergences with new low activity drying up and neither the vix or tlt making new highs. Unfortunately, I stopped out of my SPY long yesterday. I would love to re-enter, but its tough for me to find a logical stop given that we just made a low close. There is great support down near the H&S bottom around 950. But seems like an airpocket between here an there. My strategy now is to wait for a reversal and then wait for a pullback and use the lows that were made as a stop. You have a better strategy?


Jacky Poon said...


Find your analysis useful as usual, although I don't necessarily agree with the conclusion.

I think I'm with Ryan in that I think the sentiment analysis works best when used together with technical signs of a reversal - that seems to work well in this volatile market.

babaro said...

This seems to be a contrarian analysis which from my experience is a losing game. Take a look at a "pro", Mark Hulbert on Market Watch one of the best contrarians around, bull from 2007 to 2009, turned bear in March 2009 bull one more time right now.

Sure everybody wants to buy at the bottom and sell at the top but the problem is you know the bottom or the top only after they have already occurred. Bottom and top chasers are right only twice and wrong everywhere in between. Trend investors, or as you guys call them, "sheeple", are wrong twice, once at the bottom, once at the top and right the rest of the time.

Guy M. Lerner said...

Ryan and Jacky

How would you define "technical signs of a reversal"---I am not so sure there is such a thing

But I think what you are saying and it is similar to what I am saying: have a way to get in the market and a way to get out if you are wrong

Ok to be wrong but don't be wrong for long

Guy M. Lerner said...


I wish it was so easy...which trend following tool would you use? To my knowledge there aren't any

Once again, it is ok to search for a bottom or have criteria that gets you when you think there is a bottom and criteria to get you out if you are wrong

I think the potential gains are worth it if you can control your risk

Lastly, think about this: 1) from the bottom on March 9 to the first weekly close greater than the 40 week moving average, the S&P500 gained 38% over 12 weeks; this is annualized to over 150% per year 2) from that close above the 40 week moving average to the next close below the 40 week moving was 42 weeks; over that time the S&P500 gained 18%; this is annualized to about 22% per year

both types of strategies work

ryanmburke19 said...


Sorry to be late responding, but I have been traveling. I think that we are in total agreement about not staying wrong for long. I was actually asking you whether you had a better way to limit risk/seize opportunities than waiting for a pivot to develop and trading off of it. That's how I have always done it, but I am always looking for other methods to try. Re-reading my remark, I can see how it might have come off snide which was not my intention at all. I am often frustrated by my own discipline; it keeps me out of trouble, but sometimes I know it causes me to miss opportunities as well. Hence, I was wondering if you were just using a level as a stop or something else.