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Templeton’s rule of thumb has since been replaced by John Maynard Keynes’ euphemism: “The market can stay irrational longer than you can stay solvent.”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

Follow Simon on Twitter @ iSPYETF or sign up for the FREE Newsletter.

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Post FOMC Meeting Effect Tends to Kill S&P 500 Mojo

The Federal Reserve announced that the ‘big bad taper’ will stay in the closet. That’s good news. The Fed announced the same thing on September 18, which led to a three-week correction. The same thing happened in late July.

You know the spiel. When there’s a Federal Reserve meeting on Wednesday, the stock market (NYSEArca: VTI) takes a hiatus until Mr. Bernanke makes his announcement.

There’s a Federal Open Market Committee (FOMC) meeting about every 45 days or eight times a year.

More often than not the S&P 500 has a positive bias going into the FOMC meeting, but the S&P 500 ETF has lost its mojo after each of the last three FOMC meetings.

The S&P 500 chart below illustrates the S&P’s performance after the last 10 FOMC meetings.

This chart covers an incredibly bullish time period, but it’s interesting to note that – since September 2012 – the S&P 500 dropped below the FOMC meeting high every single time within the next few weeks.

More remarkable than the S&P’s post FOMC performance history is the S&P’s pre FOMC performance history.

An official Federal Reserve study shows that the ‘pre FOMC drift’ (optimism leading up to the FOMC announcement) accounts for all S&P 500 gains over the last two decades.

In other words, pre FOMC gains inflated the S&P 500 to an unbelievable degree. A full analysis (with shocking charts) of the Federal Reserve study is available here:

New York Fed Research Reveals That FOMC Drove S&P XX% Above Fair Value

Can the S&P 500 Rally another 20%?

The S&P 500 just gained 100 points in 10 days. Some suggest that further gains from an overbought condition are unlikely. This may well be correct, but with or without correction, can the S&P 500 rally another 20% from here?

The S&P 500 is trading at all-time highs and just even entertaining the idea of another rally leg makes me think of this quote:

“Anyone who believes that exponential growth can go on forever in a finite world is either a madman or an economist.”

I’m not an economist and I’d like to think that I’m no madman, but I’m starting to warm up to the idea of another sizeable rally leg.

This is partially because QE wasn’t around when Kenneth Boulding, an economist born in 1910, uttered the above words.

Although absurd when considering the economic backdrop, based on a factual and objective examination of the S&P 500 (NYSEArca: IVV) chart and investor sentiment, considerably higher stock prices are possible, even likely.

Why Now?

Stocks are nearing an overbought condition, isn’t now the wrong time to talk about another 20% rally?

The timing of this discussion is based solely on the fact that the S&P 500 (NYSEArca: SPY) has reached my long-term target around 1,750.

Technical Target Price Captured

The target was based on a 55-month long trend channel (shown in chart below) and first mentioned in the July 14 Profit Radar Report, which stated the following:

“The May 22 high did not look like a major top and the current rally doesn’t have the attributes of a major high yet either. It would be reasonable to expect some weakness with support at 1,635 followed by the next rally leg to 1,700 – 1,750.”

The October 7 Profit Radar Report confirmed the prior forecast like this: “The scenario that appears to make most sense is a quick trip into the 1,660s or 1,650s followed by another rally to new all-time highs.”

The S&P 500 chart below shows the S&P trading as high as 1,765 and Monday, tapping the upper trend channel line and capturing my long-standing target for this rally.

 

If this trend channel is going to repel the S&P 500, it needs to do so soon. Otherwise ‘persistence wears down resistance.’ Persistent trade around current levels increases the odds of higher prices.

Sentiment Analysis

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

Based on Templeton’s rhetoric, bull markets have four stages: Pessimism, skepticism, optimism, and euphoria.

For good reason the artificial QE bull market has been called the ‘most hated rally ever.’ Not a day goes by without banter against the Federal Reserve or Ben Bernanke.

Everyone and their grandmother knows that the Fed can’t print an economy out of trouble and that this experiment will end badly.

There’s no scientific way to prove this, but skepticism seems to be the predominant emotion of the market’s current stage.

However, to keep this analysis objective, we need to mention some rather bullish sentiment readings that popped up lately.

Bullish sentiment readings (bearish for stocks) include the equity put/call ratio, bullish asset allocation of Rydex traders, near record-high margin debt and perhaps, most importantly, a very elevated SKEW Index reading.

The SKEW Index was created by the makers of the VIX and – unlike the VIX (NYSEArca: VXX) – has been a trusted indicator this year.

To read about the implications of the current SKEW extreme go here: Watch Out! The S&P 500 Just got ‘SKEWed’

I personally believe that QE has changed the dynamic and the meaning of pretty much all sentiment gauges, but I also believe that understanding the composite sentiment picture holds the key to identifying the next investable low and the major top so many investors are waiting for.

Profit Radar Report subscribers know that I’ve been chronicling various sentiment indicators and actual money flow gauges for a long time. The correct interpretation of investor sentiment has kept us on the right side of the trade since the beginning of the year.

For a quick summary of how sentiment has affected trading thus far this year and an updated look at various current sentiment gauges and indicators click here: Assessing QE Bull Market Longevity Based on Current Investor Sentiment

Simon Maierhofer is the publisher of the Profit Radar Report.

Follow Simon on Twitter @ iSPYETF or sign up for the FREE Newsletter.

 

The Most Important Number in Finance is Falling … For Now

What’s the most important number in the financial world? You could ask Congress … but of course they couldn’t agree on it. The most important number in finance pulls almost every financial market in its wake. One more hint: The Federal Reserve (thinks it) is in control of it.

What is the most important number in finance?

GDP, unemployment rate, consumer confidence, or CPI?

The most important number in finance is the 10-year US Treasury Yield (Chicago Options: ^TNX).

When this number changes, almost every other number in finance changes.

The 10-year yield nearly doubled since May. The 7-10 Year Treasury Bond ETF (NYSEArca: IEF) dropped as much as 10%, a huge move for Treasury Bonds. The iShares Barclays 20+ Treasury Bond (NYSEArca: TLT) fell as much as 16%.

With rising yields came higher mortgage rates. But it doesn’t stop there. The yield rally also stifled stocks’ performance in two ways:

1) Low interest rates make bonds less attractive to investors and force them to move into stocks (NYSEArca: VTI). Bernanke calls this much-desired side effect the ‘wealth effect’ (although it robs retirees of their income).

2) Rising interest rates cause higher loan rates for businesses. This puts a squeeze on the profit margin and ultimately the stock price.

Yes, the 10-year yield is arguably the most important number in finance and therefore the chief target of Bernanke’s QE programs. The Federal Reserve buys its own Treasury bonds in an attempt to drive interest rates lower.

In the financial heist game it’s called an inside job.

Ironic QE Revenge

Ironically for much of 2013, the 10-year yield has been revolting against its puppet master (the Fed). The almost unprecedented 2013 yield rally is the opposite of the Fed’s objective.

The chart below plots the S&P 500 against the 10-year Treasury Yield.

1) The green box highlights the unwanted, unexpected and unprecedented yield rally.

2) The solid red lines marks yield resistance mentioned by the September 8 Profit Radar Report: “Yields have been rising dramatically, but may be at or near a top (at least a temporary one). As long as yields stay below 3%, odds are starting to favor falling yields and rising Treasury prices.”

Yields tumbled as much as 12% since.

3) The dashed red line shows what the S&P 500 (NYSEArca: SPY) has done since the meteoric yield rally: The S&P 500 is essentially flat and has been range bound since May. Apparently QE money is still finding its way into stocks, but rising yields prevented further gains for stocks.

4) A closer look at the correlation shows that rising yields are not always bad for stocks and shouldn’t be used as a short-term indicator.

Yield Outlook

The long-term trend for the 10-year yields seems to have changed from down to up. Over the short-term, yield may drop a bit further to digest the recent rally.

As the U.S. politicians are ‘impressively’ demonstrating (debt ceiling battle), U.S. Treasuries are not without risk. Even if/once an agreement is hammered out, the long-term futures for Treasuries doesn’t look bright.

As mentioned earlier, the Federal Reserve is deliberately inflating Treasuries. At one point the much-feared taper will begin. Via a brilliant preemptive move – probably in an effort to deflect responsibility – the Federal Reserve has already warned of a market crash (not caused by the taper of course). More details about the Fed’s market crash warning can be found here:

Surprising Fed Study – Is it Warning of a Market Crash?

Simon Maierhofer is the publisher of the Profit Radar Report.

Follow Simon on Twitter @ iSPYETF or sign up for the FREE Newsletter.

QE Haters are Driving Stocks Higher

Stubborn bearish sentiment is one of the key reasons why stocks continue to rally, essentially giving bears the finger. Bears can’t stop the QE liquidity waves. Perhaps it’s time to stop fighting them and learn how to surf them. It would be the best for bears … in two ways.

Bears, if you are looking for someone to blame for having been on the wrong side of the trade – look in the mirror.

Yes, the Federal Reserve’s financial alchemists have artificially engineered this QE bull market and yes, the economy is still lagging.

But that’s not the only reason. The stock market is actually using the bears as a springboard for higher prices.

Stock markets don’t roll over until most of the bears throw in the towel, but bears maintain a tight grip on their bearishness even at their own detriment.

This front-page article featured in the May 5, 2012 edition of USA Today sums the situation up nicely:

“Wall Street’s long-running story about how stocks are the best way to build wealth seems tired, dated and less believable to many individual investors. Playing the market isn’t as sexy as it used to be. Stocks remain out of fashion.”

I remember this time well, because my three key indicators (I call them the three pillars of market forecasting: technical analysis, seasonality and sentiment) were about to line up for a major buy signal.

In a June 3, 2012 update to subscribers I wrote that: “The S&P 500 is within our 1,248 – 1,284 target range for a bottom. Most of my studies suggest higher prices over the coming weeks and a tradable bottom due soon. While June generally falls in the seasonally weak summer period, we find that election year Junes generally sport a strong performance”

The S&P 500 bottomed at 1,266 on June 4, 2012.

Sentiment Sours as Stocks Rally

Since then stocks have rallied and sentiment has soured.

The chart below shows just how stubborn bears are. The S&P 500 ETF (NYSEArca: SPY) soared as much as 36% since its 2012 low, yet the 6-week SMA of bullish investment advisors and newsletter-writing colleagues (polled by Investors Intelligence) is closer to readings seen near bottoms than tops (red circles).

This trend was obvious in early 2013 when the financial media was outright bearish even though the Dow Jones  just pushed to new all-time highs and the VIX (Chicago Options: ^VIX) was lingering near multi-year lows.

Via the March 10, 2013 Profit Radar Report I shared this observation with my subscribers:

“The Dow surpassed its 2007 high and set a new all-time high last week, but investors seem to embrace this rally only begrudgingly and the media is quick to point out the ‘elephant in the room’ – stocks are only up because of the Fed. Below are a few of last week’s headlines:

CNBC: Dow Breaks Record, But Party Unlikely To Last
Washington Post: Dow Hits Record High As Markets Are Undaunted By Tepid Economic Growth, Political Gridlock
The Atlantic: This Is America, Now: The Dow Hits A Record High With Household Income At A Decade Low
CNNMoney: Dow Record? Who Cares? Economy Still Stinks
Reuters: Dow Surges To New Closing High On Economy, Fed’s Help

The market likes to fool as many as possible and it seems that overall further gains would befuddle the greater number. Sentiment allows for further gains.”

Small Correction, Big Effect

The minor summer correction (big black arrow) has suffocated rising optimism before it had a chance to flourish into extremes.

Now, nearly all major US indexes are near all-time highs – the Nasdaq (Nasdaq: QQQ) is outperforming every other broad market index – but sentiment is at best neutral.

From a sentiment analysis point of view, this suggests yet higher stock prices eventually (this doesn’t preclude a deeper correction).

Aside from sentiment, there is an unnoticed but very effective technical pattern that telegraphed the onset of almost every market rally since the 2009 low.

More details about this pattern can be found here:

The Secret QE Bull Market Trade Pattern that Almost Never Fails

Simon Maierhofer is the publisher of the Profit Radar Report.

Follow Simon on Twitter @ iSPYETF or sign up for the FREE Newsletter.

 

Popular German Newspaper Exclaims: Stocks Are on Drugs!

Stocks got a shot in the arm this week by favorable comments from ‘drug dealer’ Ben Bernanke. Ok, we’ve probably all heard about the drug – QE comparison, but no major newspaper has put it as bluntly and unmistakable as this one.

QE for the stock market is like drugs for a junkie. QE has the same effect (high) and the same eventual outcome (crash).

However, I had never seen this analogy on the front page of a major newspaper … until this week.

The Handelsblatt, Germany’s finance and economy newspaper, featured the “DAX on Drugs” (DAX auf Droge) article on the front page of the September 17 edition (image below).

The Handelsblatt writes (translated from German into English): “The flood of new money from central banks is driving stocks higher. For years, low interest rates have been a fast acting drug. Stocks are on a high. But more and more experts are warning of the dramatic consequences of inevitable withdrawal. Investors know that central banks are manipulating stock prices.”

That’s pretty blunt, but it doesn’t stop there: “In deed, it’s tough to find fundamental reasons for rising prices. Corporate profits are not keeping up with share prices. Even though analysts for 22 of the 30 DAX components lowered their profit forecasts, prices only moved in one direction, up.”

Stocks are Up, What’s the Problem?

Handelsblatt describes it this way: “The problem: Central banks are a temporary savior, but don’t eliminate the cause of the crisis, which is the enormous debt of citizens, corporations and countries. This creates an ever-growing addition to cheap money. Without this doping markets will crash. The longer markets are pushed up, the stronger the correction will be.”

Here’s what’s interesting about this article:

1) It graces the front page of a reputable newspaper
2) It talks about crisis even though the German DAX and US indexes are at all time highs
3) It openly and unmistakably shows the link between cheap money and share prices, calling it manipulation
4) It specifically refers to the Federal Reserve

What to Make of This

From a technical or chart analytical perspective, the German DAX is trading above strong support around 8,100. The up trend is in tact as long as trade stays above.

As a side note, there is no US traded ETF that replicates the DAX index (similar to the Dow Jones, the DAX consists of 30 ‘blue chip’ companies). The iShares MSCI Germany Index (NYSEArca: EWG) offers the best representation of the German stock market.

Germany obviously is Europe’s growth engine. The German stock market also accounts for 8.57% of the iShares MSCI EAFE International ETF (NYSEArca: EFA) and sports a close correlation to ‘our’ index of 30 blue chips, the Dow Jones .

The correlation to our Dow (NYSEArca: DIA) and S&P 500 (NYSEArca: SPY) makes the sentiment implication of the Handelsblatt article interesting.

Sentiment is a contrarian indicator, and the obviously bearish observations shared on the front page of a major newspaper are bullish for stocks. If it’s bullish for German stocks, it should also be bullish for US stocks.

If stocks rally despite obvious concerns, one wonders if anything can stop this QE bull? The following article takes a close look at this question and outlines what it will take to ‘slaughter’ this bull:

Who or What Can Kill This QE Bull Market?

Simon Maierhofer is the publisher of the Profit Radar Report.

Follow Simon on Twitter @ iSPYETF

 

These Markets are Telling Bernanke that QE Hasn’t Worked for Years

‘Don’t fight the Fed,’ has been a convenient way to explain rising prices across the board. It’s even true as far as stocks are concerned, but there are other – even more important markets – that are openly defying QE. Begging the question, when will the hammer hit stocks?

It’s not widely publicized, but Bernanke’s QE bazooka has had some spectacular misfires.

The only market that’s recovered after every misfire is equities. If you look at the S&P 500 (SNP: ^GSPC) and Dow Jones (DJI: ^DJI) you’ll see about one misfire (at worst a 20% correction) per year followed by a strong recovery.

QE had done its job as far as equities were concerned, but it looks to be a ‘one trick pony.’

The same ‘medicine’ (or drug) that’s doing wonders for stocks is causing nausea (or hangover) for other asset classes. Which ones? How about gold (NYSEArca: GLD), silver, and long-term Treasuries (NYSEArca: TLT)?

The chart below is a side-by-side demonstration of QE’s failure to launch gold, silver and Treasuries. Charted is the performance of the corresponding ETFs (GLD, SLV and TLT) during their respective crashes.

From September 2011 to June 2013 gold prices fell 38.85%. From April 2011 to June 2013 silver lost a stunning 63.42% and the iShares Barclays 20+ Year Treasury ETF (NYSEArca: TLT) is down 22.70%, since its July 2012 high.

Why? Gold and Silver

The Fed was still priming the pump in 2011, 2012 and 2013 and investors were still concerned about inflation. The same forces that drove prices to all-time highs persisted when prices hit an air pocket. The inexplicable happened!

Why? 30-year Treasuries

Treasury yields – in particular the benchmark 10-year note (Chicago Options: ^TYX) – have a huge economic impact. It’s the financial power horse that carries the economic carriage.

That’s why the Federal Reserve has been buying trillions of dollars worth of Treasuries to keep yields down. The 10-year Treasury yield is the highest it’s been in over two years. The inexplicable happened!

Why did gold and silver crash? Why are Treasury yields rising and bond prices falling?

This common sense analogy comes to mind: Another fix (aka more QE) for a junkie (aka banks) only postpones the inevitable.

How long will it be before stocks get hit by the inexplicable inevitable?

A stock market ‘event’ may not be too far off. In fact, via a series of recent studies, the Federal Reserve has started the process of officially denying liability and preparing Americans for a possible market crash.

This study is the most interesting of all: Surprising New Fed Study – Is it Preparing Americans for a Market Crash?

Simon Maierhofer is the publisher of the Profit Radar Report.

Follow Simon on Twitter @ iSPYETF.