Daily Commentary - Posted on Thursday, December 30, 2010, 9:10 PM GMT +1

11 Comments


Dec Thursday 30

Is Market Sentiment really Forecasting a Correction ?

Most recently the current investor sentiment got a lot of press around the blogosphere, regularly picking out the rapid increases in bullish sentiment and it’s most probably negative (contrary) implications for the market’s short- and intermediate term performance.

For example: For the week ending 12/23/2010, the American Association of Individual Investors (AAII) sentiment survey was reported at 63.3% bulls and 16.4% bears (bulls significantly above the long-term average of 39%, and bears significantly below the long-term average of  30%, and the highest reading for the bulls since August 19, 2005), (courtesy of) Investor Intelligence US Advisors Sentiment bulls (data at 58.8% and bears at 20.6%, and finally the Market Vane Bullish Consensus (tracking the buy and sell recommendations of leading market advisers and commodity trading advisers) at 60% , the highest reading since November 9, 2007.

But its always better to question any prevailing dogma or market adage, especially when those dogmas are rarely backed up by the numbers (the numbers don’t lie). Therefore I checked for the following setups (when they were triggered the first time, means no consecutive occurrences were taken into account):

  • Investor Intelligence US Advisors Sentiment bulls at 58.0% ;
  • Investor Intelligence US Advisors Sentiment Bulls to Bear Ratio ≥ 2.75 ;
  • Market Vane Bullish Consensus60% ; and
  • AAII Bulls > 60% or Bears < 20% and SPY (S&P 500 SPDR) at the high for the running year during the reporting week (bullish sentiment at potential market tops).

Table I below shows all occurrences and the SPY (S&P 500 SPDR)′s historical performance (since 01/01/1990) over the course of the then following 21 (1 month), 42 (2 months), 63 (3 months), 126 (6 months) and 252 (1 year) sessions, assumed one went long on close of the last session of the respective reporting week (regularly a Friday) when the Investor Intelligence US Advisors Sentiment bulls were reported at or above(≥) 58.0%.


(* no close below trigger day’s close during period under review)

When Investor Intelligence US Advisors Sentiment bulls were reported at or above (≥) 58.0% in the past,

  • … chances (and odds) for closing at a higher level 1 and 2 month later were at least in line with at-any-time chances for a higher close 1 and 2 months later ;
  • … the SPY (S&P 500 SPDR) closed at a higher level 3 months later on 14 (or 70% of the time), and 6 and 12 months later on 17 out of 20 occurrences (or 85% of the time), (significantly) better than the at-any-time chances of 69.76% and 75.95% for a higher close 6 and 12 months later .

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Table II below shows all occurrences and the SPY (S&P 500 SPDR)′s historical performance (since 01/01/1990) over the course of the then following 21 (1 month), 42 (2 months), 63 (3 months), 126 (6 months) and 252 (1 year) sessions, assumed one went long on close of the last session of the respective reporting week (regularly a Friday) when the Investor Intelligence US Advisors Sentiment Bulls to Bear Ratio was reported at or above (≥) 2.75 .


(* no close below trigger day’s close during period under review)

When Investor Intelligence US Advisors Sentiment Bulls to Bear Ratio was reported at or above (≥) 2.75 in the past,

  • … chances (and odds) for closing at a higher level 1 , 2 , 3 and 6 months later were at least in line (partly better) with at-any-time chances for a higher close 1 , 2 , 3 and 6 months later ;
  • … the SPY (S&P 500 SPDR) closed at a higher level 12 months later on 31 out of 35 occurrences (or 88.57% of the time), (significantly) better than the at-any-time chance of 75.95% for a higher close 12 months later.

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Table III below shows all occurrences and the SPY (S&P 500 SPDR)′s historical performance (since 01/01/1990) over the course of the then following 21 (1 month), 42 (2 months), 63 (3 months), 126 (6 months) and 252 (1 year) sessions, assumed one went long on close of the last session of the respective reporting week (regularly a Friday) when the Market Vane Bullish Consensus was reported at or above (≥) 60% .


(* no close below trigger day’s close during period under review)

When the Market Vane Bullish Consensus was reported at or above (≥) 60% in the past,

  • … the SPY (S&P 500 SPDR) closed at a higher level 2 and 3 months later on 31 out of 41 occurrences (or 75.61% of the time), (significantly) better than the at-any-time chance of 63.27% and 65.91% for a higher close 2 and 3 months later ;
  • … the SPY (S&P 500 SPDR) closed at a higher level 12 months later on 39 out of 41 occurrences (or 95.12% of the time), (significantly) better than the at-any-time chance of 75.95% for a higher close 12 months later ;
  • … the median gains 3 , 6 and 12 months later were 4.94%, 9.67% and 17.71% (!), (significantly) better than the benchmark’s at-any-time median gains of 2.77%, 4.68% and 10.01% during a 3 , 6 and 12 months time frame.

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And last but not least: Table IV below shows all occurrences and the SPY (S&P 500 SPDR)′s historical performance (since 01/01/1990) over the course of the then following 21 (1 month), 42 (2 months), 63 (3 months), 126 (6 months) and 252 (1 year) sessions, assumed one went long on close of the last session of the respective reporting week (regularly a Friday) when AAII Bulls were reported above 60% or Bears were reported below 20% and the SPY (S&P 500 SPDR) closed at the high for the running year at least once during the respective reporting week.


(* no close below trigger day’s close during period under review)

When AAII Bulls were reported above 60% or Bears were reported below 20% and the SPY (S&P 500 SPDR) closed at the high for the running year at least once during the respective reporting week in the past, the most notably peculiarity is the fact that the the SPY (S&P 500 SPDR) closed at an even higher level 12 months later on 43 (thereof the last 20) out of 49 occurrences (or 87.75% of the time), (significantly) better than the at-any-time chance of 75.95% for a higher close 12 months later.

Conclusions:

As always everything is possible (a market correction and/or a continuation of the recent run-up in the markets), but at least with respect to the recent bullish extremes in market sentiment indicators (even when they coincided with a market closing at or near the highest level of the running year) I couldn’t find any evidence (partly quite the contrary, see Market Vane Bullish Consensus) that  – from a historical perspective – they will be indicative for an imminent down-turn in the markets.

Successful trading, and a Happy New Year

Frank

Disclosure: No position in the securities mentioned in this post at time of writing.

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Remarks: Due to their conceptual scope – and if not explicitly stated otherwise – , all models/setups/strategies do not account for slippage, fees and transaction costs, do not account for return on cash and/or interest on margin, do not use position sizing (e.g. Kelly, optimal f) – they’re always ‘all in‘ – , do not use leverage (e.g. leveraged ETFs), do not utilize any kind of abnormal market filter (e.g. during market phases with extremely elevated volatility), do not use intraday buy/sell stops (end-of-day prices only), and models/setups/strategies are not ‘adaptive‘ (do not adjust to the ongoing changes in market conditions like bull and bear markets).

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Disclaimer

The information on this site is provided for statistical and informational purposes only. Nothing herein should be interpreted or regarded as personalized investment advice or to state or imply that past results are an indication of future performance. The author of this website is not a licensed financial advisor and will not accept liability for any loss or damage, including without limitation to, any loss of profit, which may arise directly or indirectly from use of or reliance on the content of this website(s). Under no circumstances does this information represent an advice or recommendation to buy, sell or hold any security.

I may or may not hold positions for myself, my family and/or clients in the securities mentioned here. Actions may have been taken before or after information is presented, and any opinions expressed in this site are subject to change without notice.

(Data courtesy of MetaStock , and for data import, testing, surveys and statistics I use MATLAB from MathWorks)

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Comments (11)

 

  1. RM says:

    Great blog.. thanks for sharing. One quick question – if the at anytime chance is 75%, why not just always stay long and forget about everything else? 75% seems to be good odds..

    • TradingTheOdds says:

      RM,

      probability is the likelihood that a specific event will occur (e.g. a higher close 12 months later). Odds describe the amount you’ll be paid or lose after winning / losing a wager (e.g. betting on a higher close). Expectation (hopefully positive) defines how much we can expect to win or lose on betting on a higher (lower) close.

      A probability of 75% for a higher close 12 month later with an average gain of +10%, but a remaining 25% probability for a lower close 12 month later with an average loss of 50% would make for a negative expectancy (75% * 10% + 25% * -50% = -5.00%). In addition, not everybody is able to sit out periods of large drawdowns.

      Best,
      Frank

      • RM says:

        Thanks again. That makes sense. Quick followup – do you post the expected value ever – or just the odds of winning trades. Seems like the profit expectation should drive all decision making. Like you said, you could have winning trades – but a loosing profit expectation. BTW, this is probably one of the coolest market blogs I’ve seen. Keep up the good work!

  2. Temple says:

    So sentiment only works for bulls and never works for bears? A crowded trade is a crowded trade. Maybe the sample sizes are too small. But I forgot, we are in a market where you can never lose because the Fed is going to keep the markets up unconditionally.

    What people don’t realize is that the Fed has been strategically withdrawing liquidity whenever there is a spike in the number of mortgage resets to keep mortgage rates low. With 2011 being a record year in mortgage resets, don’t expect free money to flow much longer.

  3. Ratbastrd says:

    Frank, I saw the report on the probability of higher close in relation to POMO activities back in September. I am curious if you have run the data again, given the above average number of days we have seen recently.

    Of particular interest is whether or not POMO effected performance on those days of actual activity.

    Would love to see an update on this topic given the pavlovian like response by the general market to front running POMO.

  4. […] This post was mentioned on Twitter by Frank Hogelucht. Frank Hogelucht said: New blog post: Is Market Sentiment really Forecasting a Correction ? URL: http://bit.ly/gl2tbC ($$ $SPX $ES_F $NDX $NQ_F) […]

  5. […] High sentiment readings do not necessarily imply an imminent market downturn.  (Trading the Odds) […]

  6. glerner says:

    Nicely done; if you are looking for a “holy grail” sentiment won’t be it.

    Try these things:

    1) the ratio of II bulls to bears and note how it oscillates; in fact take a garden variety oscillator, like a stochastic, and lay it over that ratio and note that it probably fits the ratio or curve of the bulls to bears pretty well; so what is the value of the sentiment indicator if it only tells you overbought and oversold? Or try this exercise….

    2) take your MarketVane data and put it on a chart and then put a price chart right on top of that; note how price goes up the number of bulls goes up and when price goes down the number of bulls goes down. Once again, what value is the sentiment indicator providing if in only mimics the direction of price?

    Several take aways from someone who uses sentiment and done all the testing:

    1) the best thing we can say about sentiment is that it identifies extremes

    2) it is in those extremes that something is suppose to happen

    3) what is that something? a) either the market mean reverts (which it does about 85% of the time with reasonable/ tolerable drawdown or expectation); or b) prices do not mean revert and a new trend starts

    This is important: failed signals lead to new trends

    Bottom line: the current environment is extreme; prices really haven’t gone anywhere for 3 weeks, so I would not call this a failure of sentiment yet

    several links address these issues:

    http://thetechnicaltakedotcom.blogspot.com/2010/09/investor-sentiment-where-is-value.html

    http://thetechnicaltakedotcom.blogspot.com/2010/09/investor-sentiment-new-thinking-for-old.html

  7. biscosc says:

    I’d like to see the results of part 4 without the SPY condition at new highs in the past week. I bet that would generally lead to bearish outcomes over the short-term.

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