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Sentiment In Equity Markets Flashing Signs Of Caution

October 21, 2010 Leave a comment Go to comments

Earlier in the week, I highlighted the bullish extremes present across a wide spectrum of asset classes, and expressed my bearish tilt on certain FX pairs and precious metals. However, I only briefly touched on equities, and so it seems prudent given the current sentiment levels that I delve more into the situation brewing in equities.

Before getting started, I want to point out that simply identifying extremes in sentiment, in of itself, does not warrant a trade, at least not by the rules from which I operate. Sentiment indicators are powerful tools for identifying  price points where reversals are more likely to occur due to herding behavior. It provides the initial edge, but what sets the trade in motion is price action, by providing confirmation of trend saturation and reference points for assessing risk.

Sentiment Indicators In Focus:

AAII (American Association of Individual Investors) – Mom & Pop investors have been warming up to stocks quite a bit lately, in fact, so much so that the 4-week average of the AAII has extended towards the highest levels seen in half a decade.

Source: Sentimentrader

II (Investor's Intelligence – (or lack of))- Newsletter writers are also showing some love for equities, not to the degree as individual investors, but none the less they are still climbing aboard. This week the II Bull Ratio rose to an overbought reading of 67.1%, but still well shy of the 75%+ readings seen back in April and January.

Composite Model by Sentimentrader This model is a compilation of various indicators including sentiment surveys, Commitments of Traders data, put/call and open interest ratios, volatility indices, breadth ratios, TRIN, and several unpublished indicators, which Jason at Sentiment has under lock and key. As one can imagine, with all those inputs, it gives a pretty well rounded view of what is going on under the market's hood.

On 10/14 the reading for the Composite Model dropped to 23%, which is only the 11th time since the data began in 2000 that a reading fell below 25%. As you can see from the table below, when the indicator fell below 25% the market had a tendency to struggle in the next 2-4 weeks, and in a few instances much longer.

For this study, I outlined the number of days it took to reach a peak, which I defined as a price high proceeding a decline resulting in a close one month later that is lower than the peak price. The peak dates were also determined by looking at the first day the model pivoted higher after crossing below 25, which is consistent with mybelief that contrarian trades shouldn't be taken until there is a pause or shift in momentum. Furthermore, I also calculated the return of the market over a two week and one month period. 

If you throw out the three occurrences which occurred at the very beginning of the 2003-2007 cyclical bull market, the market folded in the near term 6 out of 7 times by an average of 3.4% vs. the one time the market rose by 2.1%. The reason I am discounting the 2003 occurrences is due to the extreme nature of sentiment and price at that time, similar to what the markets experienced in the spring of 2009. (Surprisingly, the monster recovery in early 2009 did not push this model below 25%.)

Also, take notice in regards to the amount of time it took for a price decline to materialize. In two instances the peak was 2-3 days prior to the turning point in the Composite model, and in 4 other instances the peak was seen inside of 9 days. This means that if the current extremes are indeed creating an inflection point, then the market should begin to experience weakness very soon.  (The turn date was Monday October 18th.)

  Composite Stats
source: Sentimentrader

U.S. Dollar Sentiment – The inverse correlation between the Dollar and Equities has been a considerable focal point for both technical and fundamental traders alike. The prospects of more QE has created a "what's good for risk assets is bad for the Dollar" mantra, and everyone is buying into it. The Daily Sentiment Index, as seen below, has recently registered pessimistic readings indicating that only 3% of traders are bullish, which is below levels seen in August just before a 4%+ rally ensued, and worse than the levels seen at the 2009 trough.

US dollar DSI sentiment Oct 2010
source: Elliot Wave International

The inverse correlation between the two assets has been extraordinarily strong, and like most correlations it will eventually experience a reversion, that time could be now. With that said, a reversal in the Dollar doesn't necessarily mean equities will also reverse, however; it does suggest some caution is warranted until the Dollar begins to make adjustments to correct the high level of pessimism.

Quick Glance At The Technicals:

Chart #1 – ES contract carving out a possible Reverse Symmetrical Triangle (RST), or a megaphone, depending on who you are talking to.

Chart #2 – EURUSD looks to be rolling over and forming the right shoulder of a H&S pattern.

                      Es megaphone
   Eurusd 240

In conclusion, equities, like other risk assets, look poised to retrace in the near term. I am not as keen on being short equities as I am on remaining bearish on Precious metals and certain FX pairs. On another note, the EURGBP triggered stops at 0.8830 – that's trading, moving on.


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