Investor Sentiment: January 12, 2009

The "dumb money" and "smart money" sentiment indicators are neutral on the equity markets. While a neutral reading is not particularly telling regarding market direction, it should be noted that this is the fifth week in a row where the "dumb money" is neutral, and this is not a scenario that is generally supportive of higher prices especially with prices on the S&P500 under their 40 week moving average. The ideal situation for higher equity prices would be for the "smart money" to be bullish and the "dumb money" bearish (i.e., bull signal).

The "dumb money" or investment sentiment composite indicator (see figure 1, a weekly chart of the S&P500) looks for extremes in the data from 4 different groups of investors who historically have been wrong on the market: 1) Investor Intelligence; 2) Market Vane; 3) American Association of Individual Investors; and 4) the put call ratio.

Figure 1. "Dumb Money"

The "smart money" (see figure 2) refers to those investors and traders who make their living in the markets. Supposedly they are in the know, and we should follow their every move. The "smart money" indicator is a composite of the following data: 1) public to specialist short ratio; 2) specialist short to total short ratio; 3) SP100 option traders.

Figure 2. "Smart Money"

Hope for a better 2009 seen at the start of the year led to selling pressure last week putting the equity markets slightly in the red for the year. With neutral sentiment readings, we can no longer consider sentiment a factor in propelling prices higher, and because we have had 5 consecutive readings with the "dumb money" being neutral and with prices on the S&P500 below their 40 week moving, I have suggested that selling strength was the best course of action for those with a trading mindset. I define what I mean by "strength" in the article, "Investor Sentiment: Some Context".

Without sentiment playing a role, I like to think that stocks now must move higher on their own investment merit. They must prove themselves. What is going to be that catalyst? Another bailout program? Unlikely. Earnings? Unlikely. Better economic fundamentals? Unlikely. The only catalysts that come to mind are the hope for a second half recovery and the hope of an Obama presidency. No doubt both are compelling, but they are only hope. As I stated last week, this a bear market, and the strategy that has worked the best is sell hope, buy fear.

So what's next? Looking ahead it is unlikely that I will be bullish on equities for a multi week trade until the "dumb money" turns bearish (i.e., bull signal). And there are only two ways to bring out more bears. We either have lower prices or a protracted trading range that wears out investors.