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Investor Sentiment: Signposts to Navigate This Rally

For several weeks now, the "dumb money" has been extremely bullish and the "smart money" has been extremely bearish. These are signs that we are closer to the end of the rally as opposed to the beginning. But picking the top is an exercise in futility as the market tends to exhibit greater persistence than most of us really aprreciate. So what value is there in looking at sentiment if prices just continue to go up despite the extremes in the indicators? Well, if we look at the "dumb money" indicator in figure 1, we know that as long as the indicator stays above the upper band (see green arrow on chart), prices should continue to go higher - albeit in a grinding fashion at this stage of the rally. This is the syndrome I call "it takes bulls to make a bull market". If the indicator closes below the upper band, then the best time to sell is usually one week after this occurrence. In this instance, the market is rolling over and those late to the party are buying that dip. The data shows that this is the optimal time to sell. But these are optimal scenarios, and I should caution that optimal and stock market are rarely spoken of in the same sentence. The market is just too unpredictable. Who saw the May, 2010 "flash crash" or the 20% drop over 3 weeks in 2011 coming? If you hang around too long, you could be one of those casualties. Alas, there are no right answers or guarantees. These are just signposts that help us better understand the price action. I suspect the truth lies somewhere in between.

The "Dumb Money" indicator (see figure 1) looks for extremes in the data from 4 different groups of investors who historically have been wrong on the market: 1) Investors Intelligence; 2) MarketVane; 3) American Association of Individual Investors; and 4) the put call ratio. This indicator shows extreme bullishness.

Figure 1. "Dumb Money"/ weekly
Dumb Money Weekly

Figure 2 is a weekly chart of the SP500 with the InsiderScore "entire market" value in the lower panel. From the InsiderScore weekly report: "There was incremental improvement in insider sentiment week, however, insider selling continued to be at elevated levels. The S&P 500 and Russell 2000 flip-flopped, with insiders at the larger cap companies showing a weaker sell bias than in the prior week, and, insiders at Russell 2000 companies showing a stronger sell bias than they did a week earlier."

Figure 2. InsiderScore "Entire Market" value/ weekly
InsiderScore Entire Market Value Weekly

Figure 3 is a weekly chart of the SP500. The indicator in the lower panel measures all the assets in the Rydex bullish oriented equity funds divided by the sum of assets in the bullish oriented equity funds plus the assets in the bearish oriented equity funds. When the indicator is green, the value is low and there is fear in the market; this is where market bottoms are forged. When the indicator is red, there is complacency in the market. There are too many bulls and this is when market advances stall. Currently, the value of the indicator is 69.51%. This is the first week in 12 that the indicator has turned down week over week. Values less than 50% are associated with market bottoms. Values greater than 58% are associated with market tops. It should be noted that the market topped out in 2011 with this indicator between 70% and 71%.

Figure 3. Rydex Total Bull v. Total Bear/ weekly
Rydex Total Bull versus Total Bear Weekly

 


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