The follies of sentiment

A lot of people want to consider themselves contrarian and so as a contrarian you need to analyze market sentiment and look for extremes. Most of wannabe contrarians will blindly go bullish when they see bearish extremes and blindly go bearish when they see bearish extremes. This can result in a lot of pain because the paramaters of what is considered "extreme" are different when comparing bull markets to bear markets. Most traders/investors fail to make that adjustment and it’s the transition from bear to bull or bull to bear which wipes out or cripples accounts.

2008 was a year most so called "contrarians" got absolutely crushed and I'm sure September 2008 was when most of the damage happened. I remember that month well because I remember a lot of people came out saying that pessimism was at such an extreme and that you had to be a buyer. The panic we saw in September 2008 was similar to that seen at the July 2002 bear market bottom and so many people got fooled into thinking that the worst would soon be over. Here's a video from Charles Binderman, CEO of trimtabs in September 2008 which shows you what I mean.



During this historic rally that began in March, we've seen the same "gurus" who got burned being bullish too early in 2008 getting burned once again in 2009 being too bearish. Here's a clip on Charles Binderman on August 28 2009.



Not to pick on Binderman, but he was bullish when the SPX was at around 1200 in Sept 08 on its way down to 666 getting badly burned and was bearish when SPX was around 1035 a year later and got embarrassed again. This happened to MANY people and I think it explains the hostility towards this rally and it's why the motto of this blog will always be true.

So now what? Well, I've been either short term cautious or neutral more or less since around mid November and the market has still managed to grind higher. Not a surprise really given that as I've mentioned ad nauseum how ST bearish signals in bull markets can be ignored for quite a while as they simply get to even greater extremes.


Many traders got burned playing the contrarian in 2003 as they did in 2009. What happened? Why didn't it work? It's because it is not uncommon to see an extreme surge in bullish sentiment from traditional indicators such as II and AAII during the initial thrusts of new bull markets. It happened after the 1974 and 1982 bottoms and more recently the 2003 bottom. This "pent up bullishness" is the result of the unwinding of chronic bearish sentiment of the bear before it. Keep in mind were we are coming from folks. A year ago everyone was bracing for a 1930's style depression.

The initial thrust of the bull market that began in March of 2003 had a final push higher starting around September of that year. Just before this push sentiment indicators such as Investor's Intelligence and American Association of Individual Investors (AAII) were already at extreme levels of bullishness but the market STILL made that one last charge higher before cooling off in January 2004, transitioning into a multi-month consolidation phase. A lot of bears who were already badly wounded got taken out completely by that move as they clinged on to hopes that sentiment was "too bullish".

At present, II sentiment (which measures newsletter sentiment) has been "too bullish" since early August with a 2:1 ratio of bulls vs. bears or more ever since. Fading this has been disastrous. AAII sentiment (which measures small investor sentiment) on the other hand has been showing stubborn bearishness ever since March and only in the last week did we see a ratio of 2:1 bulls vs. bears (its back down to 1.58 this week).

Below is a graph showing the current allocation of stocks and cash by AAII members. I like this graph because it shows what people are actually doing rather than saying.



At first blush it appears as though there is too much complacency right now given the low allocation to cash and surge in the allocation to stocks and bears would say that this signals the end of the rally. Well, take a look at what happened in late 2003 to early 2004. The market was close to completing the final push of an initial bull market rally that began in 2003 which was then followed by a multi-month consolidation phase. That consolidation phase worried investors and gave hope to bears. It looked like the market had topped out and you can see how investors started raising cash again by mid 2004. But the bull market resumed and eventually made new highs by year end. I think something similar could play out this year. Perhaps we are in that "final push" stage before a multi-month consolidation.

Before this month is over or perhaps as long as early February, I believe we will see the market end its initial bull market thrust that began in March and we will enter into a multi-month consolidation phase similar to what happened in first half of 2004.

As a result of what I think will transpire I believe it's best to be selective and focus on individual names. If you can find stocks that have been dancing to their own tune (i.e. low correlation to the market) with a good chart poised to break out then go ahead and fire away because so long as general economic conditions are not hazardous if the stock has a “good story” it will be in the proper environment to play out. If your stocks are highly correlated to the market then you may want to keep a tight leash if you are fully invested and be willing to lighten up or use a covered call strategy to get some protection. As I’ve mentioned before, correlations of individual stocks relative to the market has been dropping. This makes it more of a stock pickers market now.

But the bottom line is that although we may be close to seeing the end of the first phase of the bull market, I believe higher prices ultimately lie in store. Despite so called high bullishness from things like sentiment survey’s and such how many people do you know are really bullish about the market deep down? Even those who have been bullish have been only cautiously bullish, quaking in their boots anytime the market had a pullback or quick to cut and run at the first hint of trouble. People, bulls and bears alike, are looking over their shoulder for signs of the big bad bear of 2008 to return and because of that, the LT sentiment backdrop is still in good shape even though ST sentiment foundations are shaky.