Investor Sentiment: 3 Basic Tenets to a Market Top

by Guy Lerner, The Tech­ni­cal Take

When it comes to mar­ket sen­ti­ment there are 3 basic tenets that sug­gest to me that the cur­rent mar­ket dynam­ics will lead to a mar­ket top as opposed to a launch­ing pad for the next bull mar­ket. First, investor sen­ti­ment at the recent lows (7 weeks ago) was not extreme. There­fore, the sub­se­quent rally was expected to be weak as the “rub­ber­band was not stretched to tight”. Sec­ond, when con­sid­er­ing the price cycle, which is the path prices take from low to high and back to low again, every sell sig­nal should be fol­lowed by a buy sig­nal. Our mod­els have had their sell sig­nal (April 20, 2012), but we have not had a proper buy sig­nal yet. Third, con­sec­u­tive sell sig­nals (with­out inter­ven­ing buy sig­nals) are a sign of a mar­ket top. This obser­va­tion is con­sis­tent on both a daily and weekly time frames, and it is con­sis­tent with the kind of price action we are cur­rently seeing.

When we put this alto­gether, it is dif­fi­cult to see sub­stan­tially higher prices with­out investors becom­ing more bear­ish. The best way to see increas­ing bear­ish­ness is to have lower prices. Lower prices will cer­tainly bring the Fed­eral Reserve into action. As a vari­ant to these obser­va­tions, I think the Fed­eral Reserve has been lay­ing the ground work over the past cou­ple of months based upon the unem­ploy­ment sit­u­a­tion, and this may prompt action prior to a stock mar­ket fall. In fact, the only thing that can cir­cum­vent the price cycle is QE3. The ques­tion becomes: will we get Fed inter­ven­tion before equity prices fall or after.

The “Dumb Money” indi­ca­tor (see fig­ure 1) looks for extremes in the data from 4 dif­fer­ent groups of investors who his­tor­i­cally have been wrong on the mar­ket: 1) Investors Intel­li­gence; 2) Mar­ket­Vane; 3) Amer­i­can Asso­ci­a­tion of Indi­vid­ual Investors; and 4) the put call ratio. This indi­ca­tor is neutral.

Fig­ure 1. “Dumb Money”/ weekly

Fig­ure 2 is a weekly chart of the SP500 with the Insid­er­Score “entire mar­ket” value in the lower panel. From the Insid­er­Score weekly report: “Market-wide insider sen­ti­ment was Neu­tral last week as insider trad­ing activ­ity hit a sea­sonal low-point. In fact, the num­ber of unique non-10b5-1 plan buy­ers and sell­ers was the second-lowest in our 445-week (dat­ing back to Jan­u­ary 1, 2004) track­ing period, bested only by the third week of April this year. Activ­ity will begin to pick-up late this week/early next week and trans­ac­tional vol­ume will increase sig­nif­i­cantly as insid­ers at the first-round of earn­ings reporters are free to buy/sell again. “

Fig­ure 2. Insid­er­Score “Entire Mar­ket” value/ weekly

Fig­ure 3 is a weekly chart of the SP500. The indi­ca­tor in the lower panel mea­sures all the assets in the Rydex bull­ish ori­ented equity funds divided by the sum of assets in the bull­ish ori­ented equity funds plus the assets in the bear­ish ori­ented equity funds. When the indi­ca­tor is green, the value is low and there is fear in the mar­ket; this is where mar­ket bot­toms are forged. When the indi­ca­tor is red, there is com­pla­cency in the mar­ket. There are too many bulls and this is when mar­ket advances stall. Cur­rently, the value of the indi­ca­tor is 67.52%. Val­ues less than 50% are asso­ci­ated with mar­ket bot­toms. Val­ues greater than 58% are asso­ci­ated with mar­ket tops. It should be noted that the mar­ket topped out in 2011 with this indi­ca­tor between 70% and 71%.

Fig­ure 3. Rydex Total Bull v. Total Bear/ weekly