Saturday, December 25, 2010

Investor Sentiment: Extremes Persist

It doesn't take a rocket scientist (or Wall Street analyst ~ a downgrade?) to figure out that investors are extremely bullish on the equity markets.  Such extremes in sentiment will usually (85% of the time) lead to better risk adjusted buying opportunities in the future.  In other words, the next best time to be a buyer of equities will be when investors are bearish not bullish as they are now.  The markets don't have to go down just because everyone is bullish, but if you are a "believer" and buyer at these levels, then you will need to identify a market top and get to the exits before the next guy to extract profits.  This is a very crowded trade and identifying the top is a tall order.

As you can tell I am bearish and not buying the hype, but like last week, I think it is worthwhile to explain what I mean by "bearish".  This should NOT be a bull market top leading to a bear market.  Bear markets come about when "buying the dip" fails.  In other words, this overbought, over bullish market should correct providing a better risk adjusted buying opportunity in the future.  Failure of a bounce to materialize at that point is a harbinger of a bear market.  So bearish means that I expect to see a correction leading to a better risk adjusted buying  opportunity, and this buying opportunity usually coincides with investors turning too bearish (i.e., bull signal). 

Let me clarify my time frame, and this should help clarify the analysis.  The average time between a bear signal and the next buy signal is approximately 80 trading days.  The next bull phase, when it comes, should last about 100 trading days.  So my analysis is not suitable for the day trader looking to get the next 2% move.  I would think what I am talking about here is for the trader who is intermediate term in nature and who tries to position themselves for major swings in the market.  There will be a lot of ups and downs between now and the next quality buy signal.  

Remember, the market does not have to go down because everyone is bullish and it may go higher.  If it does, so be it.  I will participate if the reward to risk profile, as I have defined these metrics, improves.  Trading and investing is about managing risks.  If you don't want to assume that responsibility of managing risks, then you should be a buy and hold kind of investor. 

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) Investors Intelligence; 2) Market Vane; 3) American Association of Individual Investors; and 4) the put call ratio. The "Dumb Money" indicator is more bullish to an extreme degree, and this is a bearish signal. 

Figure 1. "Dumb Money"/ weekly

Figure 2 is a weekly chart of the SP500 with the InsiderScore "entire marketvalue in the lower panel.  From the InsiderScore weekly report: "Sellers outnumbered buyers for the sixteenth consecutive week, extending a record streak for our reporting period (dating to January 1, 2004). While the strong sell bias continued, the number of sellers did fall more than -20% week-over-week and, for the first time in nine weeks, Buy Inflections outnumbered Sell Inflections. Volume will continue to decrease due to the holidays, the closure of trading windows and the fact that we're coming off a period of very heavy selling. "
Figure 2. InsiderScore "Entire Market" Value/ weekly

Figure 3 is a weekly chart of the SP500. 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 66.33%, and this is the third highest value in 10 years of data.  Values less than 50% are associated with market bottoms.  Values greater than 58% are associated with market tops.
Figure 3. Rydex Total Bull v. Total Bear/ weekly

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Burt said...

Thanks for this blog. I read every post.

I am confused by the sentiment numbers. Everyone I know is still bearish. They all are either out or waiting to get even to get out. I also read that there are continual redemptions from stock mutual funds.

Who are these bullish survey respondents? Nobody I know.

Guy M. Lerner said...


Happy Holidays and thanks for reading; there are 9 different pieces of data that make up the 3 different charts you see here; when you sum it together the "dumb money" is bullish and the "smart money" - as represented by company insiders that are bearish

I cannot change the data - but the data has worked very well in the past but as always there are exceptions; there is no holy grail

While everyone you know might be out of the market or on the sidelines waiting, the data "says" otherwise; this is why I try to use as much data as possible from as many different angles as possible

hettygreen said...

I was wondering if you could advise when the sentiment indicator was last higher than it is now and the respective readings.

I know you are still bullish on Treasuries and was wondering what your line in the sand was for the 10 and 30? Seems to me the least risky time to become a longer term owner of these securities over the past number of years has been at or near the summer solstice.

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