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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