The basis of sentiment studies is that when too many investors – particularly retail investors – are bullish, its a contrary signal suggesting things are overbought/ due for an eventual pullback of some sort. Conversely, when too many investors are bearish, its a contrary signal suggesting the market has sold off too much from pessimism, and the market is likely to rally.
I follow a number of sentiment indicators, and they are assigned weightings to calculate my Bear-o-meter compilation. That compilation is a reasonably good indicator of the risk/reward tradeoff on the US broad large capped stock market. Its especially valuable when the indicator reads at one of the extreme ends of its spectrum – unlike the reading I got 2 weeks ago, which was neutral.
I only measure the Bear-o-meter once a month – typically in the first week of the new month. But in between those readings, I still keep an eye on sentiment indicators that are used within the Bear-o-meter. These indicators are – Put/call ratio, VIX, and Smart/Dumb money.
Today, I thought we could look at these three indicators to get a feel for market sentiment. My conclusion based on what I am seeing on these three indicators is that the market is becoming more risky since my early July reading of the Bear-o-meter. Lets take a look where these indicators are right now.
Were you to draw a linear regression line on the above chart, you would find that the put/call ratio tends to average a little under the 1:1 ratio of put volume vs. calls. That makes sense. Most of the time, markets go up. Option traders and hedgers tend to bet in the positive direction favoring calls. Early this month when I read this level for incorporation into the bear-o-meter, the reading was closer to 1:1 – a normal level. I’ve found that a move below 0.75:1 indicates that option traders are too complacent. They are buying considerably less puts – meaning they are skewed towards markets continuing higher even after a strong market return. They’re usually wrong at the extremes. The current level of 0.71 suggests a strong bullish bias, or high complacency. Why hedge with puts when the market shows no signs of abating? Like I said, these traders are usually wrong at extremes, and that’s where they are right now.
The VIX is another indicator using options to read sentiment. But instead of trading volume, it measures option premiums. Options are priced according the their time value (how much time is left on the option before expiry) and the volatility that investors anticipate within that time period to expiry. This “implied volatility” is really where the meat of option pricing lies. That variable changes rapidly as investors become more or less bullish/fearful of the outlook for the market or individual stock. Thats why the VIX is sometimes called the “fear index”. Although the VIX will also include the optimism premium built into calls during a bullish market, the bigger moves in premium will come from the shrinkage of that implied volatility in calls and the surges in put premiums when traders become pessimistic.
The VIX chart is not in “complacent” territory by my definition. But there is no doubt its direction indicates more and more comfort with the market valuations of late. Still, its a neutral reading at the end of the day.
Smart money/dumb money spread
This one gets me into trouble sometimes, but facts is facts. Some investors make better decisions as a group than others. For example, institutional investors and commercial hedgers are on average more “correct” in their market outlook than are retail mutual fund, ETF investors and stock traders. The value of the smart/dumb indicator is that it pits these two groups and looks for extreme divergences in opinions. It stands to reason that often both “smarties” and “dummies” will be on the same side of the coin. It’s when you see a drastic polarization of opinion/outlook that we should take heed. Sentimentrader.com follows trading volume and fund flow of these groups and has created a chart that I find amazingly accurate at extremes.
When the ratio of smart/dumb optimism falls below -0.25, we start to get into irrational exuberance territory. Right now that ratio sits at -0.5, meaning that dumb money is about twice as enthusiastic about the market outlook as is smart money. Note on the chart above that this condition could last a few months, and could even get deeper into the “bullish dummy” territory. But it basically never stays this skewed forever. This is a bearish sign.
It may take a week, a month, or a quarter. But sentiment of the wrong people has become a bit too optimistic . Keep an eye on the charts for any sign of rolling over.
BEFORE THE WEEKEND I’LL BE POSTING A BLOG ON SOME PREDICTIONS FOR THE CANADIAN INVESTMENT AND ECONOMIC ENVIRONMENT. MY CALLS FOR A FALLING LOONIE AND UNDER-PERFORMING STOCK MARKET OVER THE PAST 6 YEARS HAVE SADLY, BEEN RIGHT – READ MY PAST BLOGS IF YOU NEED PROOF OF THOSE CALLS. MY OUTLOOK HASN’T CHANGED. IN FACT ITS GROWING MORE PESSIMISTIC. IN THE NEXT BLOG, I’LL BE COVERING WHY I’VE BECOME EVEN MORE PESSIMISTIC. I PIN MUCH OF THE BLAME ON THE CURRENT FEDERAL GOVERNMENT, WHICH I DID FORESEE AS THE PROBLEM AS FAR BACK AS LATE 2015. TRUDEAU FANS WILL NOT LIKE THIS BLOG, SO IF YOU ARE ONE OF THEM, DON’T TUNE IN THIS FRIDAY. I WON’T RESPOND TO ARGUMENTATIVE COMMENTS, NOR WILL I POST THEM.
HAVING SAID THAT, THE BLOG WILL COVER SOME PRACTICAL INVESTMENT (AND OTHER) OPTIONS THAT INVESTORS WHO AGREE WITH MY PROGNOSIS WILL, HOPEFULLY, FIND POTENTIALLY PROFITABLE AND USEFUL. SO, ITS NOT JUST A WHINE AND COMPLAIN BLOG -THERE WILL BE PLENTY OF PRACTICAL STRATEGIES TO PROFIT AND IMPROVE.
I’m on vacation next week, back with more blogs in August. Feel free to post comments to this blog below. I’ll be around this week to answer them.
I’ve been watching UUP and it seems to be breaking downward And Only FXE is moving up – from you view is this significant Change ? If so, what is it telling us? Is it time to be favouring the Euro zone or the opposite – time to favour the US ?
UUP is the USD vs the Euro, Yen, Pound, CDN$, Krona and Franc. So as yo know, its not just the USD vs Euro (FXE is Euro)–but yes, your observation is correct in that the comparative still offers evidence that the Euro is outperforming the USD. Buying it in a USD account might make sense. Harder to calculate in a C$ account, because the potential for a C$ upmove against the USD (which FXE trades in) and offset–meaning the C$ was comparatively moving up against the Euro
So, keeping it simple, I’d perhaps consider using FXE in an account that you maintain USD’s in –easier to track if you are actually profiting or not.
Hope that isn’t too muddy
Do you need to rant? Get every thing out before you head north? LOL
You got it Carey! Good comment!
I should have added how is the cycling going this year? are you still training?
Thanks for asking Carey–obviously no bike racing this year, which is too bad because I had been aiming and very prepared for the biggest race of my cycling career (Canadian National Time Trial Championships in PQ which would have been early this month). Once I learned it & everything else was cancelled, I reset my goals to just turn the summer into a “distance” summer. Oh, plus I am eating more pastries and drinking more beer, not needing to maintain the super low bodyfat necessary to win a bike race. Pants are tight, lemme tell ya!
Every week I do at least one ride approaching 100 miles (160 km) and next week I am doing a doozy with a friend…220 km loop he has created. He calls it the hard-man loop. Lots of climbing in that big ride too–I’m gonna hurt after that one!
Hi again Keith,
A question I cannot seem to find an answer for: For a Canadian, how can I short U.S technology without U.S dollars? Can we short the BMO ETF ZQQ? If we can, how do you know how much it costs to carry this short position?
In the U.S, it’s easy, you can simply buy the ETF PSQ.
Thank you sir!
Matt–yes you can usually short any ETF unless your brokerage doesn’t allow it–if so, find another broker who does if you still want to do it.
Re costs–that’s a question your broker can discuss with you. They will have a standard interest rate, and there are industry capital requirements to short (you will need to open a separate short account)–call your broker and they will walk you through it.
I listened in to your presentation for the Kitchener share club this week…and also saw you at the Guelph share club a few months ago. Very interesting and informative. I’m not a technical investor, but I do look at a few indicators to gauge the market…always interested in different perspectives.
Last week I was a bit spooked by a bunch of stuff, and sold off my US Tech (QQQ). I am sitting on about 10% of my total household investable assets in US cash. I like holding US cash because I find the investment options are far greater in USD, but now I’m just so confused. I missed the boat on gold for now I think…US stocks are too frothy for me at the moment. I was thinking of currency…possibly the Euro, FXE, but not sure….or VWO…but again, I feel like it will correct before it goes up. Any suggestions as to how to protect my USD for the short term?
Yes–as noted to Ralph in another comment, I like the Euro. Longer termed you’ll be fine in the USD but it may be a year or so of underperformance — or less…things move quickly these days!
Short the Nasdaq with HQD-tsx
Anyone interested in shorting the US tech sector is the equivalent of standing in front of a tidal wave. No matter how much one “thinks” the sector is overbought, it can go up much further for much longer than one can remain solvent shorting it. In conclusion, if someone thinks about shorting US tech, the answer is to lock yourself in a closet until the idea passes.
I love it! Beyond overbought corrections, I think you are likely right!