The concept of using sentiment indicators in our market timing (risk/reward) analysis is this: When too many people are upbeat and happily investing in stocks, the key words being “too many”, it’s an overdone (overbought) market that should sell off sooner rather than later.
The opposite is true for too many pessimistic and downtrodden investors. This signals an oversold market that should rally soon. I’d like to look at a three of my favorite sentiment indicators now, and offer some potential interpretation of how markets might play out into the new year based on sentiment observations—and seasonal/cyclical studies.
Smart money/Dumb money
On Friday of this week, I’ll be doing the BNN 6:00 MarketCall show.
I will be talking about the Smart/Dumb money indicator amongst other things. Interestingly, I often get “hate mail” when I refer to retail investors (that’s, um, you and me, folks) as dumb money on the show. But “the truth doesn’t care about your feelings”, as outspoken American conservative Ben Shapiro likes to say. You and I may not be “dumb” when it comes to investing (the fact that we study TA and try to apply some discipline to market analysis suggests we are not) – but our peers within the retail world of investing often do not do much in the way of analysis. Further—it’s clear that their Advisors – who often focus on selling managed products – or their shops’ approved list of stocks- do not apply much analysis either. Thus—our group, on the whole, is less savvy when it comes to investing.
Sentimentrader likes to pit our group (dumb money) against the smart money. Smart money includes pension managers, institutional investors, commercial hedgers, etc. these guys, on the whole, tend to make better investment decisions than our group. But, like our group, there are a few stand-out bad decision makers amongst them too. So we look at both groups for their net opinions, not their individual opinions.
When the groups reach coinciding extreme levels of optimism and pessimism you have a change in the risk/reward potential for the markets. On the chart above, courtesy sentimentrader, you will note that it’s not quite there yet for smart money pessimism (blue line) , but the dumb money (red line) optimists are out in full force.
Put to call ratio
Put to call is a ratio of the volume of put contracts being traded vs. call contracts. There are normally less puts than call being traded – given the fact that market tend to rise more often than fall. That, and the common usage of covered call writing to generate income on stocks. So you should expect to see 1/1 or somewhat less than 1/1 puts traded to calls traded on the market. A reading of 0.75 puts for every one call suggests too much optimism – whereas a reading of about 1.25 puts traded for every call suggests too much pessimism. Right now, the put/call ratio suggests there is no excess to either the optimism or pessimism side.
The AIM model surveys Advisors and Retail Investors together – for reasons noted above in the “dumb money” survey. It’s a little like the dumb money model, except that it includes advisory newsletters and advisor surveys into the mix. The chart below suggests a very high level of optimism by that group at this time. As you’ll note on the chart—this model is often at the overly-optimistic level, so it shouldn’t be taken as a sole indicator. It is a much better “buy” indicator as and when pessimism gets too low, as you will see by the lows on the chart corresponding nicely with lows on the stock market.
Market cycles & strategy
Virtually every seasonal chart or statistic you can look at will show the tendency for markets to rally into the New Year – with a finishing bump into the first week or so of January via the “Santa Rally”. The second half of January into late February can be a bit of a yo-yo. Bullish tendencies begin in early march and last well into the spring.
On top of the seasonal tendencies, we have another cycle coming into play this January. The presidential inauguration takes place on January 20th of this year. Markets tend to remain strong into that date from an historic viewpoint.
Putting it all together, it is my opinion that markets will continue to rally until somewhere between the Santa Rally and Inauguration day. Sentiment indicators like smart/dumb money may reach their optimistic sell points somewhere in that period. It is at that point that markets may hit a short termed peak near or before inauguration day – and possibly sell off a bit or trade in a choppy range for a while. Should this scenario take place, it might be viewed as an opportunity to sell your questionable stocks, looking to rotate into more favorable positions as conditions present themselves.