Monday, January 5, 2009

Investor Sentiment: Some Context

In my most recent post on investor sentiment, I suggested selling into strength and I suggested that the optimal time to do this was during this week. An astute reader asked the question: what do I mean by strength?

This is a great question because all too often market commentators make a "call" without the context of time (i.e., when things you predict might occur) or without the context of draw down (i.e., how much pain in the form of losses you have to suffer while being wrong before you get it right).

So let's define the question. I am basing my analysis on the following two observations: 1) investor sentiment, as defined by the investor sentiment composite indicator or "dumb money", is neutral for 5 consecutive weeks; and 2) price is below the 40 week moving on the S&P500 for 5 consecutive weeks. So the question becomes: when these two conditions are met, how does the S&P500 perform over the next 13 week period?

So we "buy" the S&P500 when both the "dumb money" is neutral and the S&P500 is below its 40 week moving average for 5 consecutive weeks. Positions are "sold" after 13 weeks or when the "dumb money" becomes bearish (i.e., bull signal). Commissions and slippage are not considered in the analysis. This is analysis is based upon 18 years of data.

If you only traded this strategy, you would have generated 11 trades. Only 2 of these trades would have been winners, and you would have lost 550 S&P500 points with only about 10% market exposure. This is quite significant. The majority of trades occurred in the 2001 - 2002 bear market or the current bear market.

But to give a little more context to the analysis and to try and answer the question of "what do I mean by strength", let's look at the maximum favorable excursion (MFE) graph for this strategy. See figure 1.

Figure 1. MFE

What is MFE? MFE measures how much a trade runs up before it is closed out for a loss or a win. Look at the caret in figure 1 with the blue box around it. This caret represents one trade. This trade ran up 2.5% (x-axis) before being closed out for a loss of 9% (y-axis). We know the trade is a loser because the caret is red.

So what can we tell from the MFE graph if we bought the S&P500 when both the "dumb money" is neutral and price is under the 40 week moving average? In 8 out of 11 instances, prices ran up less 2.5%. These are the carets in figure 1 to the left of the vertical blue line. Or to put it another way: the ultimate intermediate term top was identified within 2.5% of the initial signal in 8 out of 11 instances. In the other 3 instances, the S&P500 moved between 5% to 7% higher before heading lower.

So what do I mean by selling into strength? Based upon the scenario that I have defined, one can expect a top about two thirds of the time within 2.5% of the signal. We are now entering that window (i.e, the 5th week) where we would expect the market to begin to stall.

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