Sentiment Sinks, But So Will Market

Some measures of investor sentiment have sunk to extreme lows, which in the past has been a good contrary indicator and a buy signal. For example, see the chart of the Investor’s Intelligence Survey at Bespoke. SentimenTrader.com also publishes its “Dumb Money” index, which is literally 100% reliable. (If you are not a member, but are a RealMoney.com member, you can see the latest chart here.) And there are more such indicators.

Do not ignore these indicators. They are now a piece in the puzzle and all pieces must fit.

So, how does the piece fit? First, prices are the best indicator of sentiment. If you look at the IWM chart, you will not see any fear, let alone panic. The QQQQ chart is looking shaky, but again, not panicky. The SPY chart looks unpleasant, but also not panicky. Even the XLF chart is not falling off the face of the earth, but is in a well-defined down-trend channel. However, if you look at the DJIA chart, you will see impending doom. Of course, the DJIA is a price-weighted index, and means nothing. However, a lot of traders are still in the habit of looking at it, and I suspect it has an out-sized impact on the sentiment surveys.

So, some of the negativity is un-justified at this point, and that is proven by the Vix. The DJIA was not scary enough last week to motivate an excess of put buying. Neither the Vix, nor the sentiment indicators, are down to their March lows yet. But they will be. They will be. Historically, the S&P 500 rarely strays far from the banks; see the chart here. And since the banks are testing the October 2002 low, so will SPY – unless “it’s different this time.”

There is room for sentiment to worsen before we get a negative-sentiment rally. See the article here for Ned Davis’s opinion:

“We may need more extreme pessimistic sentiment before we can call sentiment clear-cut bullish.”

Negative sentiment doesn’t just pop-up out of nowhere. In fact, it is negative sentiment that is causing the market to fall here. The wheels are coming off of the banking system and the economy, and the crowd has it right. If you have read The Wisdom of Crowds, you know that groups of ordinary people can perform jaw-dropping feats of computation. It’s not a good idea to fight the crowd while it is rational. You can only beat the crowd when it goes crazy, and traders have not reached that point yet. But it is coming, and that would be a good time to take some profits on short positions, and definitely not a good time to press short bets.

A few years ago, Laszlo Birinyi published a detailed study of sentiment surveys and found that they are not good timing tools. I think that they are important indicators, but can’t be used for short-term timing. Birinyi probably agrees that they are important now since he now publishes his own blogger sentiment survey every Monday.

Nevertheless, there is a group of traders gearing-up to bet on a negative-sentiment rally this week. One example titled “Brazen and Raw Negativity” comments on the extreme negativity of hedge-fund managers:

“Have all of these managers already made their negative bets? Who is left to sell or short?”

This group of traders trying to fade sentiment will be defeated in the coming week. First, additional short sellers are not needed to push stocks down. All that is needed is for bids to be pulled, and stocks can free-fall. Also, short-sellers are not the only sellers in the market. The public is still sitting on some very nice gains in tech stocks, and Russell-2000 stocks, and they will rush to lock-in profits as soon as the QQQQ and IWM crack.

There is also no potential good news coming that will reverse the market. Banks are still white-washing the numbers and plan to continue doing so, the Iranians will not give up their nuclear program, the economy is continuing to contract, and while some earnings reports may be OK, guidance for the next quarter will almost certainly be reduced for most companies. The Fed is being conspicuous in it’s silence over plunging bank shares, and unless a giant meteor filled with oil crashes into, and fills the Grand Canyon with light crude, there is no catalyst to spark a rally here.

So, all the pieces of the puzzle fit like this: some traders will bet on the sentiment data this week and cause one last rally. It will fail, the market will plunge through the March lows, sentiment will pin-the-needle on the gauges as befits this historic crash, and at the height of the panic, some short sellers will begin to take profits. Their buying will trigger a vicious snap-back that will squeeze the late-coming shorts and burn off all of the negative sentiment. Then the next leg down will begin, and will run until there is some sort of spark-of-life in the economy.

I would put some more detail onto the above scenario, but this post is long enough as it is. You get the idea though, right?

A few more notes:

Item: Take a look at the QQQQ chart. Notice the sharp, and very high-volume rally on Thursday. I believe that was the “last hurrah” for tech as it could not break-out even with oil falling almost $5. The chart pattern is now almost identical to that of SPY when I correctly predicted its demise in “Stick a Fork in the SPY” on June 3rd. QQQQ closed under the “third fan line” on Friday (as I draw the lines) and IWM is very close to doing the same.

Item: Jim Cramer has turned rabidly against financial stocks. While late-to-the-party, he usually arrives in time to make a few bucks. However, he is still in denial about tech, so that is a sign that there are lots of bulls who still have not barfed-up their pet techs. I will likely be adding to my QID position this week.

Item: Stick a fork in the XLE. Homework: draw three fan lines from the March low and you will see that XLE has rolled over. NOT good for the S&P 500.

Note: I have some ideas about the Israeli/Iranian situation and will try to post them tomorrow.

This entry was posted on Saturday, June 21st, 2008 at 6:09 pm and is filed under Investing. You can follow any responses to this entry through the RSS 2.0 feed. Both comments and pings are currently closed.