Want to get an edge on the market? Sentiment might be a good place to look.
Sentiment tells you how the majority of investors are positioned in a particular market, giving you clues about the next short-term move.
Most of the time, it's an exercise in futility. The bulls and bears are about equally balanced, rendering the market neutral.
But occasionally, investors all jump onto the same side of a trade. And that spells opportunity.
When everybody's on the bullish side, there's no one left to sell. When everybody's on the bearish side, there's no one left to buy. Either way, the market is extremely unbalanced. At that point it's simple – you load up on the other side of the trade and wait for the market to reverse.
Not so fast, Money Map Press Chief Investment Strategist Keith Fitz-Gerald said in a recent interview.
"When sentiment hits extreme levels, whether bullish or bearish, it makes me very leery," said Fitz-Gerald. "Markets have a tendency to zig, when they should zag. Sentiment can hit very extreme levels and still not trigger a pending reversal."
There are sentiment gauges for almost every stock, bond, currency or commodity market you can think of – with literally dozens of indicators like volatility, put/call ratios, breadth of volume, insider buying, etc. And while those indicators are usually neutral, they sometimes flash buy or sell signals that move investors to trade.
Government Printing Press Neutralizes Volatility Index
The most widely known sentiment gauge is the Volatility Index, or VIX: a forward-looking measure of the implied volatility of Standard & Poor's 500 Index options. A high value corresponds to a more volatile market and therefore more costly options, which can be used to lay off risk.
The VIX is often referred to as the "fear index," because it represents a measure of the market's expectation of wild price swings over the next 30-day period.
The highest VIX readings occur when investors anticipate that huge moves in either direction are likely. When investors perceive neither significant downside risk nor significant upside potential the VIX will be low.
The lowest ever reading for the VIX was 9.31 in December 1993 – the market stayed essentially flat for the next 14 months.
The highest ever was on October 24, 2008, when the VIX reached an intraday high of 89.53 – just after a series of triple digit drops in the Dow Jones Industrial Average highlighted by a 679 point drop on October 9. The market would go on to lose over 2500 points in the next 5 months as the shorts made a killing.
Since then, the VIX has been in a long-term downtrend, signaling decreasing volatility. It is currently bouncing along in the low 20s after an up-tick to almost 40 in November when the market staged a rally to current levels.
But the index doesn't lend itself to predicting which way the market is set to move, only an abundance or lack of trading volume. And Fitz-Gerald says even that may be irrelevant in today's markets.
"With the trillion dollars of liquidity the government is pumping into the markets, and a fivefold increase in lending capacity, the VIX has been rendered useless as an indicator," Fitz-Gerald said. "You just can't rely on it anymore."
Two Markets Flashing Bearish Indicators
Right now, however, one of the key stock market sentiment gauges, the Investors' Intelligence survey is flashing a warning light.
Each week, Investors' Intelligence polls the writers of 140 investment newsletters and determines whether the publisher is bullish, neutral, or bearish. It has conducted this survey every week since 1962.
Last week, the survey showed the percentage of bearish newsletter writers had fallen to 16.5%, which is the lowest level since June 2003, and the third-lowest bearish percentage in 22 years, according to Bespoke Investment Group.
Bullish sentiment also declined slightly from 50% to 48.4%. And as both the bullish and bearish camps declined, the amount of newsletter writers looking for a 10% correction rose to 35.10% – the highest level since March 1992.
It suggests the market has reached extreme optimism.
When bullish sentiment gets so high, contrarian investors will tend to go short. But while bullish sentiment often peaks before market declines, bullish sentiment by itself is typically not a reason to turn bearish.
But as bearish sentiment rises, the average performance of the S&P 500 generally increases in the following one and three month periods.
When bearish sentiment is under 20% (as it is now), the S&P 500 averages a one-month return of 0.38% with positive returns 58.8% of the time. Over the next three months, the S&P 500 averages a return of 1.25% with positive returns 63.4% of the time.
Investors Holding Less Cash
The retail money market survey is also flashing bearish signals, Jason Goepfert, a noted sentiment expert recently told Daily Wealth, part of the Agora Inc. family of investment newsletters that includes Money Morning.
The Investment Company Institute collects data on the cash investors hold in their brokerage accounts. When small investors are optimistic, they spend cash on stocks. Conversely, they shun stocks and build up large amounts of cash when they're scared.
Goepfert says whenever money market assets climb over 10% of the market cap of the Standard & Poor's 500 Index, it's a great buying opportunity. Conversely, when money market assets fall below 5% of the S&P's market cap, it's a good time to sell.
Right now, retail investors hold just over $1 trillion, or about 8% of the S&P's market cap in money market funds – a balanced market.
But while 8% isn't extreme, cash levels have plunged sharply from the 15% levels they reached in November 2008. The only other time in the last 30 years cash balances dropped as quickly as this was in mid-1982 to mid-1983, when cash levels plummeted from 15% to 8% in one year. Over the next 12 months, the market tumbled about 15%.
But Goepfert says plenty of other gauges are flashing bullish readings, so he recommends taking only a 25% bearish position on the S&P 500 and waiting for confirmation of the trend.
Fitz-Gerald also recommends a wait-and-see approach.
"An indicator like this makes me doubly leery," he said. "Retail investors could be jumping on the gold bandwagon and buying gold stocks. When you hear your taxi driver talking about gold it's time to tighten your stops and check your support and resistance levels."
News & Related Story Links:
- Bespoke Investment Group:
Bearish Newsletter Sentiment Hits a Six Year Low