Sunday, February 8, 2009

Investor Sentiment: No Edge Provided

Investor sentiment is not providing an edge as the "Smart Money" and "Dumb Money" indicators continue to hold to the neutral ground.

Figure 1 (a weekly chart of the S&P500) shows the "Dumb Money" indicator. The "dumb money" 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.

Figure 1. "Dumb Money"

The "dumb money" is neutral on the markets, and they have been that way for 10 consecutive weeks. Over this time period, I have contended that higher prices were not likely unless sentiment became more bearish. There were too many bulls caught on the wrong side of the trend, and more bulls needed to be converted to bears before a multi month, counter trend rally could unfold.

However, a new wrinkle has happened along the way. Last week, the NASDAQ 100 printed its highest close in 14 weeks. In other words, we have higher prices in spite of the neutral sentiment picture, and this situation is rather unusual. Before discussing how unusual this is, let me digress and define for you the price cycle.

The price cycle is the path prices take from low to high and back to low again. Market practitioners have devised many tools to divine these highs and lows, but few of these work with any consistency. I use investor sentiment to define the lows and highs of the price cycle as fear and greed are fairly consistent behaviors at market bottoms and tops, respectively. Exhaustive research has shown that the best, most accelerated market gains occur when the majority of investors are on the sidelines and fearful of further market losses. As the market turns, those on the sidelines pile back into the market chasing performance and propelling prices higher. This is when our price cycle begins. When those same investors are overly bullish and complacent in their outlook, stocks are generally facing headwinds as those already invested are “all in” and there are few investors on the sidelines to keep prices moving higher. At this point, we expect the price cycle to end.

So why digress about the price cycle? The price cycle, which started on November 21, 2008, ended January 9, 2009 because history tells us that after 5 weeks of neutral investor sentiment and lackluster breath we should expect lower prices. And we did get lower prices - i.e., the worst January ever by the Dow Industrials and S&P500.

So what happens when one price cycle ends? In 44 of our 45 signals since 1990, investor sentiment will turn bearish before higher prices are seen. In other words, higher prices are typically preceded by the "Dumb Money" indicator turning bearish, which is a bull signal, and this begins the price cycle anew.

However, let's get back to the NASDAQ 100. We now have higher prices yet we never passed through the "dumb money" investor turning bearish phase. This is our wrinkle.

The prior occurrence of this wrinkle occurring is noteworthy, and this is January, 1995, which is the kick off to the mega bull run of the late 1990's. However, there are some key technical differences from the current time period when compared to 1995. For one, prices in 1995 were coming out of 24 month consolidation and this was a very good launching pad for a monster bull run. Currently, this looks like a "v" shaped bounce, which generally is not sustainable. Secondly, back in 1995, prices were above their 200 day moving average by the time the breakout had occurred. Lastly, the "smart money" was bullish back in 1995. It should be noted that the "Smart Money" indicator has been bearish for 15 consecutive weeks now.

Figure 2 shows is a weekly chart of the NASDAQ Composite with the "Smart Money" indicator. The "smart money" refers to those investors and traders who make their living in the markets. Supposedly they are in the know, and we should follow their every move. 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.

Figure 2. "Smart Money"

So this is our conundrum:

1) Higher prices can occur in the absence of the "dumb money" turning bearish, but it is not the norm.

2) The NASDAQ 100 is the only major index showing "strength". The Dow Industrials, S&P500, and Russell 2000 continue to trade to resistance levels, and based upon the current sentiment picture, these indices represent better selling opportunities.

3) The NASDAQ 100 is providing leadership, and proprietary studies show that this is good leadership in that returns in this speculative index can lead to out performance in the S&P500. Anecdotally, investors "believe" in technology as a market leader, and strength in this index could lead to broader market strength.

4) From a technical perspective, this is not 1995.

At present, the sentiment data is not very useful. If it wasn't for the positive price action in the NASDAQ 100, I would say something like, "sell strength" or "the time to get bullish is when everyone is bearish". But I cannot say that as I respect the price action too much. For now, it appears we have a split market with no clear cut edge.


Th said...

Just wanted to say that i really enjoyed your stuff on realmoney and i'm glad you're back sharing the wealth.



Guy M. Lerner said...

Thank you very much!

Tyler said...

Excellent post Guy! Very insightful and helpful. thank you.

Hope all is well and that your vacation was nice.