One Measure of Investor Optimism Hits Extreme Low

The latest American Association for Individual Investors (AAII) poll shows a significant drop in optimism.

Only 27.2% of individual investors are bullish on stocks. That’s the lowest reading since April 2013.

How powerful of a contrarian indicator is this?

The chart below plots the S&P 500 against the percentage of bullish AAII investors.

The dashed green lines mark bullish reactions to similar readings in the past, the red lines bearish reactions and the gray lines neutral (at least short-term) reactions.

 

Well, there are six prior instances with two bullish, two bearish and two neutral outcomes. Not much of an edge.

The AAII survey generally delivers noisy data and hardly ever works as a stand-alone contrarian indicator.

Compared with the many other investor sentiment gauges I follow, this reading stands out as a rogue extreme.

It’s one of those data points that should be taken with a grain of salt, but as long as the S&P 500 stays above 2,100, it shouldn’t be ignored either.

Simon Maierhofer is the publisher of the Profit Radar Report. The Profit Radar Report presents complex market analysis (S&P 500, Dow Jones, gold, silver, euro and bonds) in an easy format. Technical analysis, sentiment indicators, seasonal patterns and common sense are all wrapped up into two or more easy-to-read weekly updates. All Profit Radar Report recommendations resulted in a 59.51% net gain in 2013 and 17.59% in 2014.

Follow Simon on Twitter @ iSPYETF or sign up for the FREE iSPYETF Newsletter to get actionable ETF trade ideas delivered for free.

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The Only Indicator That Foresaw a Persistent S&P 500 Rally with No Correction

MarketWatch reports that most people missed the recent rally? Why? Obviously because nobody saw it coming. Here is one indicator that persistently suggested further gains (this indicator also explains why so many missed the rally).

I spend a lot of time plotting intricate charts illustrating technical patterns and developments, sentiment extremes and seasonal biases.

Perhaps my most impactful chart this year was featured in the 2014 S&P 500 Forecast (published by the Profit Radar Report on January 15).

This chart combined all my analysis into one simple S&P 500 projection for 2014 (view S&P 500 projection chart here).

If you click on the link above you’ll notice that the projection was about as accurate as anything in the financial world can be.

I’d like to think that charts have value, but the effectiveness of any chart crafted since early May pales in comparison to this rudimentary and unscientific, but uncannily accurate indicator.

Headline Indicator or ‘Blind Guides’

The headline indicator is simply an assessment of media sentiment. Unfortunately, many retail investors listen to the media, making this a helpful contrarian indicator.

Below is a brief chronicle of the media’s uncanny prowess to support the wrong side of the trade along with commentary by the Profit Radar Report.

You’ll be surprised to read just how wrong the financial press has been (the S&P 500 chart below includes even more media headlines).

April 30, 2014 – S&P 500 at 1,884

April 30, Profit Radar Report: “The old and chewed-out ‘sell in May and go away’ adage is getting a lot of play these days. I get suspicious when our carefully crafted outlook becomes the trade of the crowd and a crowded trade. How will the market fool the crowded trade?

The media’s take:

  • CNBC: “Why sell in May adage makes sense this year: Strategist”
  • IBD: “Why investors expect to sell in May and go away”
  • MarketWatch: Risk of 20% correction highest until October

May 11, 2014 – S&P 500 at 1,878.48

May 11, Profit Radar Report: “How will the market fool the crowded trade? A breakout to the up side with the possibility of an extended move higher.”

The media’s take:

  • Bloomberg: “The next liquidation crisis: What are the signals?”
  • CNBC: “I’m worried about a crisis bigger than 2008: Dr Doom”
  • Bloomberg: “U.S. markets on brink of 11% correction”

June 11, 2014 – S&P 500 at 1,944

June 11, Profit Radar Report: “Different day, same story: Stocks are near their all-time highs, but the media treats this advance with outright contempt. Below is a small selection of today’s headlines. We can’t dismiss media sentiment as retail investors (unfortunately) listen to the media.

The media’s take:

  • CNBC: “Cramer: Prepare for stock decline”
  • WSJ: “How long can stocks maintain all-time highs?”
  • MarketWatch: “3 reasons why the Dow shouldn’t be at 17,000”

June 25, 2014 – S&P 500 at 1,959

June 25, Profit Radar Report: “It only took one small down day (Tuesday) to reinvigorate media fear mongers.”

The media’s take:

  • Yahoo: “S&P’s Stovall says be careful before jumping into stagnant market”
  • Yahoo: “’It looks like a peak:’ Robert Shiller’s CAPE is waving the caution flag”
  • CNBC: “Wall Street’s biggest bull calls for a correction.”

Irony at its Worst

A correction would actually be healthy, but a watched pot doesn’t boil.

The June 25 Profit Radar Report explains: “The media’s continuous market top calling, artificially extends every rally. We saw this in April/May. Although media pessimism isn’t as pronounced today as it was in April/May, it’s enough to be considered a bullish wild card.

Bull markets die or correct because of ‘starvation.’ The market needs potential buyers to fuel rallies. That’s why good news tops are dangerous, because they suck in so many buyers and leave few sellers. Where there’s no buyer, there’s no price increase. ‘Scary’ media headlines disturb this cycle and provide continuous ‘ammunition’ for the bull.”

Today – S&P 500 at 1,973

On Monday the S&P 500 closed at 1,973. What does the media say?

  • CNBC: “Why this could be as good as it gets for stocks”
  • Yahoo: “Common sense says look out for a market top”
  • USA Today: “History says July is cool time to own stocks”
  • WSJ: “Dow nears 17,000 as rally gains steam”

Yes, you saw correctly, there are actually two headlines with a bullish connotation, but the most fitting headline comes from MarketWatch.

Dow flirts with 17,000, but most people missed the ride

Hmmm, let’s see if the media can crack the mystery behind the missed rally.

It is obviously premature to order a coffin for this rally (or the entire bull market), but several indicators – one of them is the ‘sudden drop’ indicator – suggest caution.

This ‘sudden drop’ indicator has a flawless record since the beginning of the QE bull market in 2009. Is it reason to worry.

Here is a detailed look at the ‘sudden drop’ index: S&P 500 ‘Sudden Drop’ Index at Historic Extreme

Simon Maierhofer is the publisher of the Profit Radar Report. The Profit Radar Report presents complex market analysis (S&P 500, Dow Jones, gold, silver, euro and bonds) in an easy format. Technical analysis, sentiment indicators, seasonal patterns and common sense are all wrapped up into two or more easy-to-read weekly updates. All Profit Radar Report recommendations resulted in a 59.51% net gain in 2013.

Follow Simon on Twitter @ iSPYETF or sign up for the FREE iSPYETF Newsletter to get actionable ETF trade ideas delivered for free.

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.

Buying Climaxes Soar to ‘Flash Crash’ High as 30% of S&P 500 Stocks Peak

Buying climaxes are at the highest level since April 2010. The April 2010 highs were closely followed by the May ‘Flash Crash.’ Are the current conditions similar to 2010 and should we be concerned about a ‘Flash Crash-like’ event?

There were 864 stock buying climaxes last week. What is a buying climax and why is that significant?

Buying climaxes happen when a stock (or index) makes a 12-month high, but closes the week with a loss. They are a sign of distribution and indicate that stocks are moving from strong hands to weak ones.

iSPYETF previously pointed out elevated buying climaxes in articles published on February 13 (112 buying climaxes) and April 10 (347 buying climaxes).

Both instances were followed almost immediately by corrections (see chart). Last week’s number of buying climaxes – 864 – eclipses the 112 and 347 climaxes seen prior to the February and April corrections.

In fact, the current reading is the second highest total since 2004 and is surpassed only by the 1,079 buying climaxes in the week of April 30, 2010 (see chart insert).

It sounds dramatic, but it’s worth pointing out that the April 2010 price high was chased by the May ‘Flash Crash.’

Does that mean another ‘Flash Crash’ event is around the corner?

The ‘Flash Crash’ was preceded by historic sentiment extremes and an incredibly concerning equity put/call ratio. In an April 16, 2010 note to subscribers (now known as Profit Radar Report) I warned that:

The equity put/call ratio is 45% below its six-month average. The message conveyed by the composite bullishness is unmistakably bearish. Once prices do fall and investors do get afraid of incurring losses, the only option is to sell. Selling results in more selling. This negative feedback loop usually results in rapidly falling prices.”

Current conditions aren’t as extreme as they were in April 2010, but they should be of concern to investors, nonetheless.

It doesn’t take a ‘Flash Crash’ to hurt a portfolio. A slow and determined correction can do the same thing ‘Chinese drip torture-style,’ – slower, more painful, but with similar results.

Like in 2010, it will take a ‘watershed’ event, a decline that spooks enough investors, to get the ball rolling.

A break below important support will likely be just such an event. The Profit Radar Report already pinpointed the must hold support level that – once broken – will lead to lower prices.

Despite Extreme VIX Movements, Option Traders are ‘Lukewarm’

According to the VIX, option-traders are complacent and have been complacent for many months. The bearish VIX implications however, have not been confirmed by two historically accurate options-based sentiment indicators.

The VIX soared 43% on Monday, collapsed 19% on Tuesday and is up nearly 30% today. Just before that, the VIX fell to the lowest reading since February 2007.

Although the CBOE Volatility Index (VIX) is rushing from one extreme to the next, options traders as a whole have been remarkably ‘non-committal’ or lukewarm from a sentiment point of view.

This sentiment deviation is illustrated by the chart below. The CBOE Equity Put/Call Ratio has been narrowing in a triangle shape formation void of extremes. The 2010, 2011 and 2012 market highs were preceded by at least one daily reading below 0.5 and a drop of the 10-day SMA below or at least close to 0.55.

The 2013 Equity Put/Call Ratio low was at 0.54 on March 6 (the 10-SMA has yet to fall below 0.6). The recent all-time highs caused no put/call sentiment extremes.

Quite to the contrary, the VIX has rushed from one extreme to the next. For that reason, the Profit Radar Report noted back in November that the: “VIX has been of no use as a contrarian indicator and will be put on ‘probation’ until it proves its worth again.” Yes, the VIX is still on probation.

A SKEWed Market?

The CBOE publishes another options-based index like the VIX, it’s called the CBOE SKEW Index. The SKEW in essence estimates the probability of a large decline.

Readings of 135+ suggest a 12% chance of a large decline (two standard deviations). A reading of 115 or less suggests a 6% chance of a large decline. In short, the higher the SKEW, the greater the risk for stocks.

The chart below juxtaposes the SKEW against the S&P 500. Last week the SKEW fell as low as 117. This was odd as readings below 115 (dashed green line) are generally bullish for stocks.

Conclusion

The CBOE Equity Put/Call Ratio and SKEW index proved to be valuable contrarian indicators in 2010, 2011 and 2012. The current option-trader sentiment is not bullish, but it’s not as bearish as one would expect to see at a major market top.

To an extent, option-trader sentiment is in conflict with other bearish sentiment extremes discussed recently. When sentiment indicators conflict, technical analysis and support/resistance levels become even more valuable.

The April 10, Profit Radar Report highlighted key resistance at 1,593 and stated that: “A move above 1,593 followed by a move back below 1,590 will be a sell (as in go short) signal.”

As long as prices remain below key resistance, the trend is down until stocks find key support.

S&P 500 and Gold Sport Two Misleading Sentiment Anomalies

Groupthink tends to create losses for most and juicy gains for a select few. The S&P 500 and gold show some compelling sentiment extremes that could be misleading if viewed in isolation.

I love a good “reverse lemming” or contrarian trade. Investor sentiment is one of the best tools to spot a contrarian setup.

Even though the market has been stuck in a rut, there are a number of sentiment extremes. Many of those sentiment extremes however, parade some curious anomalies.

Love to Hate Gold

Last week Bloomberg reported that: “holdings in gold-backed exchange-traded products reached a record 2,629.3 metric tons yesterday,” an extreme sign of gold optimism.

More people than ever flock into ETFs like the SPDR Gold Shares (GLD) and iShares Gold Trust (IAU). The fiscal cliff, QE3 and QE4 probably have something to do with that.

Gold futures traders on the other hand are quite bearish. Only 10% of futures traders are bullish about gold.

I have never seen such polar opposite sentiment for the same asset class.

Let’s Buy Stocks Before They Drop

Bank of America just reported that its private clients (retail investors) are selling stocks at the fastest pace in 19 months (see chart below). Such eagerness to sell tends to occur around bottoms not tops.

The behavior of option trades is the exact opposite of BofA retail investors. According to the ISE exchange, traders bought 208 calls for every 100 puts.

Such a rush into call options has pretty consistently led to lower prices in the past.

If you spend more time looking at other sentiment gauges, seasonality, technical patterns, cash flow, cycles of stocks vs. broad market indexes, and correlations between asset classes, you’ll find even more anomalies.

The thing is, anomalies – curious and unique as they might be – cause analysis paralysis, they don’t provide trade setups.

When in doubt, stay out or sign up for the Profit Radar Report to find low-risk trade setups. Low-risk setups provide sizeable profit potential in exchange for negligible risk, even in environments like this.

Simon Maierhofer shares his market analysis and points out high probability, low risk buy/sell recommendations via the Profit Radar Report. Click here for a free trial to Simon’s Profit Radar Report.