Beware the dreaded P6

I find myself in the bear camp these past couple of months not because of the dogmatic, miserable fuck bullshit from the permabears which helped bankrupt God knows how many traders, but because the evidence just keeps piling up.  There's a market strategist named Don Hays who I have followed off and on since 2000. I think the word "followed" is not the right way to describe it...reading his commentary is more accurate. Anyhow, he's a top down strategist and his "system" consists of 3 pillars which are valuation, monetary conditions and psychology (investor sentiment). I like to keep tabs on the last pillar, psychology because it tends to be pretty good at marking significant medium and LT turning points. This pillar of his system is composed of a variety of sentiment indicators such as investor survey's, insider activity and fund flows. Psychology is ranked in 6 levels ranges from P1 to P6 with P1 being the most bullish condition for the market (bearish sentiment is extreme) and P6 the most bearish for the market (bullish sentiment is extreme). It is rare to see P1 and P6 readings and when they get triggered they almost always happen near significant turning points in the market. The only time a P1 reading was notably early was during the 2008 crash, which is understandable given the once in century type collapse that it was.

The bad news for the bulls is that a P6 reading was just triggered. The last time it happened was in June of 2011 near the peak of the market which led to that 20% correction (A rare P1 reading was then registered near the depths of that nasty correction). The other time prior to 2011 a P6 was registered was in May 2008 which was the selling opportunity of a lifetime.

It's important however to keep things into context. In bull market conditions, extreme bullish sentiment  leads only to corrections (which can be scary) while in bear markets they mark the end of a dead cat bounce which then leads to major damage via new lows (as was the case in 2008). So, a P6 doesn't automatically mean the end of the world. In 2004 for example, a P6 reading was registered in March but only led to a 10% correction which took 6 months to play out before the bull market resumed with a vengeance. Having said that though, it's clearly not a good time to be putting money to work during a P6 condition even in a bull market for odds are very high you will be able to get better prices if you wait. It also seems likely the correction will be greater than 10% given the gains we've seen in the recent 2 years and let's face it, after a 165% run in 5 years, we could be in for a major scare much like in 1987 which occurred 5 years after a great 5 year run as well.

So, this also begs the question. Should I consider making a bearish play here? The short answer is yes but because we are not in a bear market and tops can take several weeks to form especially when you have this kind of momentum with the market still very close to the highs, be prepared to be very frustrated if you attempt to do so and so give yourself plenty of staying power. Buying long dated puts would be the best solution. I am strongly considering to do so but since I'm already in 60% cash with my major holding non-correlated to the market I'm already defensively positioned and can patiently wait for the market to show signs of cracking first while keeping my sanity in tact. If history is any guide we will see a couple of small dips followed by sharp rebounds before the "real dip" starts. If I'm wrong and the market simply tanks on a dime then at least I won't be caught with my pants down as I'm already 60% in cash. The bottom line for me is that I can be patient with any attempt to profit on any downside. If I was closer to fully invested then I'd be raising cash in a hurry.

Bottom line here is that it appears the risk/reward for the market in the medium term (6-12 months) is piss poor. We can certainty go higher before we go lower but it would very likely be a running on fumes/blow-off type move in my opinion. The last time I felt this negative about the market's prospects in the medium term was in the early summer of 2011.