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Market Sentiment Gives Clues to Next Big Move in Stocks


June 14, 2013
Chad Karnes, Chief Market Strategist

The stock market’s latest pullback has some bulls on edge.  After an uninterrupted rally that started in November, the recent pullback deleted 5% of gains and has thus far become the largest correction since then.

My article "Are Technicals Signaling a Storm Ahead" already suggest a heightened sense of insecurity, and now I'm watching a few key things concerning market sentiment (or mood of the market) to keep us ahead of a deeper correction.  

How to Use Sentiment Data

If I told you that a certain penny stock trading on the Nasdaq (NYSEARCA:QQQ) hit record highs in May 2013, you likely would dismiss it and say so what?  I most certainly would, mainly because we have no clue if the stand alone data is meaningful information or not. 

But if I told you that the amount of aggregate tradng in penny stocks just surpassed the previous peak levels that occurred in Feb 2000 (coinciding with the Nasdaq’s all time price high), we start to get a better idea of how the data can be helpful. 

By itself it may not be meaningful, but when compared to the same data throughout history, it can be eye-opening, especially in recognizing extremities.  This is how a lot of sentiment analysis works.  The Nasdaq penny stock action is really put in perspective when it is revealed that typically penny stock volume peaks at market peaks and bottoms at market bottoms. 

The below table and simple chart of the Nasdaq (NYSEARCA:QID) captures the penny stock volume at recent major market peaks and troughs (in red).  A pickup in penny stock action on the Nasdaq (NYSEARCA:PSQ) may be warning of a topping market as speculators again go to extremes chasing penny stocks and a rising market’s trend.

The Bigger Picture

This is just one sentiment example and may just be coincidental and not proving anything, which is why in the April ETF Profit Strategy Newsletter I looked at over 25 other sentiment indicators to get a better idea of current levels compared to historical market peaks and troughs.

An example of that report is shown below with a key takeaway that almost all sentiment indicators have reached or were again very near their all time high bullish levels recently.  This data overwhelmingly shows that the market (NYSEARCA:VTI) was likely much closer to a major long term selling opportunity than a major buying opportunity.

Three of the many popular adviser surveys are shown below as they were included in the Newsletter analysis.  Two of the three recently reached their all time high bullish levels and the third was in the upper levels of its historical past.  By comparing the levels associated with market tops to levels associated with the 08-09 low it is clear that there is a distinguishable difference between bullishness during market tops and bearishness during market bottoms. 

Advisors in these surveys become most bullish near market tops and most bearish near market bottoms, exactly opposite of what they should be.

We summarized our findings by saying, “Sentiment can be a very powerful driver of share prices (NYSEARCA:IWM) as the herding mentality of investors can takeover near market tops and bottoms.  Being able to recognize such times in history can help you stay clear of irrational investment decisions.”

Abenomics and Sentiment

Japan’s recent market rise was accompanied by record smashing bullish sentiment as measured by the Tokyo Stock Exchange’s margin and commitment of traders (COT) data.  For only the second time in history Japanese margin traders as a whole actually carried net positive positions (profitable).   Moreover, large speculators were the net longest they have ever been since at least the early 90’s.  Typically these traders are considered the “dumb money” because over the long run they are usually on the wrong side of the trade.  No doubt, this would not last, and it didn’t.

We knew sentiment was ripe for a major reversal in the Japanese stock market’s (NYSEARCA:EWJ) uptrend and that a reversal in the positions of the long margin traders and speculators would lead to a deep Japan (NYSEARCA:DXJ) decline, we just needed to wait for price to confirm the trend change before we could capitalize on the price and thus sentiment reversal.

On 5/22 that trend reversal occurred and on 5/29 we advised going short the Japanese market in our Weekly ETF pick by buying the ProShares UltraShort Japan ETF (NYSEARCA:EWV).  We also recommended put options.  EWV was at $21.17 then and rose above $23 within a week in a great example of how a shift in sentiment can move the markets very quickly.

What to Expect

With sentiment in the U.S. markets having already reached peak bullishness it is likely the majority of buyers have now already bought in.  This means the risk is now likely to the downside.  With the recent pullback in price, we may finally be seeing the technical picture breakdown.  Next to follow would be overall sentiment deterioration that would drive prices lower. 

Once two key price levels I am watching are breached to the downside, it is likely the large amount of bulls will start to reverse their positions and switch their overall sentiment to a more neutral or bearish stance, just as the Japanese market is doing now. 

The ETF Profit Strategy Newsletter focuses on fundamentals, technicals, sentiment, and common sense to follow the world’s markets.  We publish a twice weekly Technical Forecast and weekly ETF Picks to stay ahead of key trends and turning points. 

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CommentsAdd Comment

BellyUp said on June 20, 2013
  Good call on what was coming Chad. We got a very definite break below 1600.
The move to SP500 1588 must have instilled fear of further losses in the common investor who enjoyed a rather uneventful ride up the roller-coaster from Nov 2012 till last month.

My expectations for the Fed to prevail this time around, were shattered to pieces.
Maybe Ben was surprised too in the face of the dramatic slide of the markets in the last 2 days. I surely was.
Being only 30% invested since 2 weeks ago with one third of that in VXX, smoothed the ride at least.
Chad, ETFguide said on June 17, 2013
  Bubblegum, following the technicals and using stop losses should help you avoid such losses in the future. Also, avoid trying to pick tops (or bottoms) as much as possible. That is a losing game. Instead, waiting for a confirmed trend change (S&P below 1600 for starters) helps shift those odds into your favor. Yes sentiment is extreme and yes fundamentals seem to have peaked out (or at least slowed down), but until the technical trend confirms a downturn, we should avoid getting too short too early. Fundamentals and sentiment can stay extreme for elongated periods, but once the technical trends change then all the recipes for a broader market decline will be in place.

BellyUp, discussed in our Technical Forecast, last Wednesday's pullback took the shape of a falling wedge as 1600 held as support. Until 1600 fails the longer term trend is still technically up. However, the Fed also was front and center May 22, the recent market peak, so it may be losing its luster.

BellyUp said on June 17, 2013
  Once again, put all the indicators predicting a market collapse on one side, and the Fed on the other, and guess what? - The Fed wins. The markets are up big time today and with the dovish Fed meeting this week, you have a perfect brew for continuing strength and momentum to take oit the recent market highs and leave the short sellers holding the bag. Bottom line, no one knows the future so Stay with the trend until it changes. That's where the profits are.
BubbleGum said on June 14, 2013
  Fascinating article. Thank you.
The only critique I have is that extreme sentiments can hold or slowly keep increasing for a long time, even months, before an actual peak is reached.
That in return causes investors to think a drop in the markets is just around the corner and stay away from the rally or worse, use ultra-shorting ETFs and become big losers (as I have following one of your previous Analysts during 2010-2011).
Have etfguide found more certain ways to identify when such peaks are trully upon us?
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