Do Sentiment Extremes Still Matter in a Fed-Manipulated Stock Market?

Investor sentiment used to be one of the most effective contrarian indicators known to man. Then the Federal Reserve came and change the rules. Do sentiment extremes still work as a contrarian indicator in the fake QE bull market?

Famous investor John Templeton said that: “Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.”

This used to be the most important rule of thumb in investing – give investors what they want. When everyone wants to own stocks, sell them yours. When everyone wants to dump stocks, buy theirs.

This rule of thumb used to work pretty reliably until an unrelenting and indiscriminate buyer entered the market place – the Federal Reserve. No matter the price, the Federal Reserve will buy it.

Templeton’s observation was based on the assumption of finite demand. The Federal Reserve has created infinite demand.

Templeton’s rule of thumb has since been replaced by John Maynard Keynes’ euphemism: “The market can stay irrational longer than you can stay solvent.”

Does that mean that investor sentiment has become obsolete as a contrarian indicator?

Has Sentiment Become Obsolete as Contrarian Indicator?

I always like to look at hard data, but truth be told there is not much hard data about sentiment extremes.

The chart below plots the S&P 500 (SNP: ^GSPC) against the percentage of bullish advisors polled by Investors Intelligence (II).

We see a nearly unprecedented wave of euphoria in late 2010. At that time many different sentiment and actual money flow gauges were literally off the charts.

Those extremes, however, had no immediate impact on stocks. In fact, the S&P 500 (NYSEArca: SPY) kept rallying for another couple months (gray boxes). Eventually the S&P 500 lost 20%.

In October 2011 investor sentiment had soured (bullish for stocks) and the S&P 500 was near important support at 1,088. In my October 4 update to subscribers (now known as the Profit Radar Report), I recommended to buy at S&P 1,088.

Since the October 2011 low the S&P 500 has rallied over 65%, but investor sentiment has never eclipsed the 2010 euphoria … until now (more below).

This rally has truly been the most hated rally in history and not a day goes by without commentary shooting against the Federal Reserve’s QE.

The worry that QE will end badly (along with political uncertainty) has provided the ‘wall of worry’ needed to propel stocks higher.

Euphoria is Back

Although we’ve seen blips of optimism, euphoria didn’t re-enter the picture until this week.

I follow literally dozens of sentiment and actual money flow indicators. Most of them show the biggest wave of optimism since the 2010 ‘sentiment peak.’

The Most Effective Use of Sentiment Extremes

The above chart shows that excessive pessimism is a better contrarian indicator than excessive optimism.

Optimistic sentiment extremes generally translate into rising risk, but not necessarily immediate pullbacks.

That doesn’t mean we should ignore current extremes. The S&P 500 (NYSEArca: IVV) and Nasdaq Composite are butting up against serious multi-year resistance right now, and disappointment over failed attempts to overcome such resistance could easily send stocks lower.

Where is this resistance and how serious is it? The two charts featured in the article “Nasdaq and S&P 500 Held Back by ‘Magic’ Resistance” pinpoint this ‘magic’ resistance level.

Simon Maierhofer is the publisher of the Profit Radar Report.

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Optimism on the Rise – Should You “Fear the Cheer?”

A crowd follower does the opposite of a contrarian. Like a red light camera, contrarian indicators are effective because most people aren’t aware of them. But what happens when – as is the case right now – contrarian indicators go mainstream? 

In the first week of January investors shoveled $22 billion back into equity funds around the world. This is the second highest inflow on record reports Bloomberg.

Bullish sentiment of investment advisor and newsletter writing colleagues (polled by Investors Intelligence – II) jumped to the highest level since September 18, 2012 (the S&P 500 declined 9% thereafter).

Retail investors polled by the American Association for Individual Investors (AAII) are the most bullish they’ve been since February 9, 2012.

Am I forgetting something? Oh yeah, the VIX just hit the lowest reading in 72 months.

Investors are so bullish, it must be bearish for stocks, right?

Contrarian Gone Mainstream

It normally pays to fear the cheer. But a trap is only a trap as long as it remains hidden and extreme sentiment is only a contrarian indicator as long as it remains contrarian. Contrarian indicators gone mainstream don’t work (remember the much publicized, ultra-bearish Hindenburg Omen in August 2010?).

Extreme optimism alerts or “fear the cheer” headlines have just gone mainstream. A small sampling of Friday’s headlines is listed below:

“Where’s the wall of worry?”
“Why VIX’s recent plunge may be bad for stocks”
“Earnings disappointments ahead”
“Is the crowds cheery mood reason to fear the rally’s end?”

For the first time in quite a while the VIX, II, and AAII polls are delivering a generally bearish signal. However, the media skepticism caused by investor optimism may well negate the bearish contrarian implications (is there such a thing as an inverse contrarian signal?).

Even though the VIX is unusually low, the chart below shows that as of late a low VIX alone doesn’t automatically translate into lower stock prices.

How the Market May Trick “Inverse Contrarianism”

The media can change its tune on a dime and the market usually takes the route least expected. One way the market may shake out or convert the pessimistic optimists is simply by grinding higher. Nothing is as persuasive as rising prices.

Or, the market may decline a bit – make the bears feel safe – and then deliver another rally leg.

Whatever route the market chooses, I wouldn’t make any buy/sell decisions purely based on sentiment at this time.

Key Inflection Point Ahead

More gains in the form of a final push higher would harmonize well with my technical indicators and technical model, which sees a key inflection point just ahead.

This key resistance (I call it inflection point because the S&P 500’s reaction there should set the stage for weeks to come) is the same type of resistance level that pinpointed the 2011 market top and subsequent 20% waterfall decline.

Key inflection points like this always provide low-risk trade opportunities. Why? The potential for gains is so much larger than the risk of losses because you know exactly when you are wrong. You can go short with a stop-loss just above resistance or long once resistance is broken with a stop-loss just below.

The latest Profit Radar Report highlights this key inflection point along with actual trade recommendations.