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By: Chris Rowe — November 9, 2010

Here's How To Spot This Market's Top

One thing that we watch out for here at TycoonU is whether or not our opinion seems to be exactly the same as everyone else's.

I'll give you an example ...

Recently, we noticed that everybody on earth was expecting the market to sell off right after the FOMC meeting.  It was the old "buy on rumor, sell on fact" expectation.  At first I thought that was going to happen also.  But then, after noticing that everybody in the world was saying the same thing, we started telling our members that the market probably wouldn't sell off right after the announcement. 

We turned out to be right, thanks to our non-herd following approach.

Some market sentiment readings showed excessive bullishness 1-2 weeks before the recent FOMC announcement.  But we saw the level of bullishness decline slightly right before the FOMC announcement, which is in line with what I just mentioned above.  Now that the market has broken out higher, we will likely see even more excessive bullishness. 

The question on everybody's mind right now is: "Should I buy this breakout, or would I be buying at the top?"

While I don't know the answer, I do know that optimism reaches its peak around the same point that the market is reaching ITS peak.  I also know that the majority of people are pessimistic at market bottoms, which is exactly when investors should be buying.

According to EPFR Global, retail investors have invested about $2 billion into U.S. equity funds since September, which is about 25% of the total $8.4 billion that has come in.  This may not seem like a lot of money relative to the amount of money traded each month.  For comparison, $23 billion was pulled out of equity funds in August by retail investors. 

The American Association of Individual Investors polls about 170,000 retail investors asking if they're bullish, bearish, or neutral on the next six months.  At their last reading this past Thursday, 48.23% of investors said they were bullish, which (with the exception of the reading one week prior, at 51.23% bullish) is the highest level since February 22, 2007 -- right before the market dropped by over 500 points in a day (see chart below, when the reading was at 53.85%). 

Bearishness at last reading was at 29.79%, and the reading the week before that was at 21.60%, the lowest reading since January 12, 2006 when the reading hit 19.08%! 

Another way of reading the sentiment is to consider the difference between the levels of bullishness and levels of bearishness.  It's called the bull-bear spread.  The bullish minus bearish sentiment had a reading of 29.6 percentage points just two weeks ago, which is higher than it has been in all of the stock market highs made since 2007.

Generally speaking, to have a healthy bull market you need to have short-sellers in the market shorting stock.  But the more bullish people are, and the less bearish people are, the smaller the number of short-sellers and short positions is going to become.  Even if there is a significant short position, they are not going to remain committed to those short positions, but instead will trade around them quickly in fear of an upside explosion.

The reason short sellers are so important to a bull market is that, when the market declines fast, the intermediate-term bottom is usually put in by the short-sellers buying back the stock that they sold short.  You generally don't see many bullish heroes coming in to take new long positions ... they wait for the short-sellers to "cover" first.  The initial buying pressure is usually profit-taking from the Bears.

Back to last week: The bullish investors polled by the AAII slipped from 51.23% to 48.23%, and bearish investors increased from 21.6% to 29.79%.  But it is important to note that a large amount of those polled gave their answers before the Fed decision on Wednesday.  It will be interesting to see what this sentiment survey produces this Thursday, now that investors have witnessed the stock market breaking its April highs.

As we try to position ourselves here, it's important to look at several different sentiment indicators ... 

Another widely followed sentiment survey is the Investors Intelligence Advisors Sentiment survey.  This survey has not yet shown an overly bullish market, but it's a weekly survey, and they will post the latest results tomorrow.  Their most recent survey showed that bullish advisors accounted for 46.7% of those polled, while bearish advisors accounted for 24.4%.  Tomorrow we'll have a complete idea of how the advisors felt, in aggregate, after the Fed announcement last Wednesday.

The rule of thumb with the Investors Intelligence Advisors Sentiment reading is that we are in "dangerous territory" once the bullish advisors account for more than 50% of those polled.  That isn't the "sell signal" though.  Strong sell signals are given once the bullish reading gets up to 55%, and then reverses lower.  So the soonest we could see a strong sell signal would be in two weeks, because the reading would have to first move above 55% tomorrow and then move down the following week.  That would be an outrageously huge move in the reading in a 2-week span, so I highly doubt that would happen.

But considering what the AAII reading is telling us now, if we see the Advisor Sentiment reading move above 50%, that would be a reason for us to be extra cautious on our bullish positions.  In the meantime, we don't want to fight the trend, which is currently bullish.  We will play the upside -- but cautiously -- increasing our hedges (having some bearish exposure or creating strategies to reduce downside risk) and tightening stop-losses.

Sentiment indicators are called leading indicators because they generally give us early signals.  Most indicators are lagging indicators that tell us about what has already occurred.  Sentiment indicators give us signals that are often a precursor to something happening.  The great thing about these indicators is that, once we get the signal, we usually have time to position ourselves for safety.

To keep posted with what the various sentiment indicators, breadth indicators and price patterns are forecasting, sign up with any one of the TycoonU services today, and you will get access to our daily morning audio cast "Morning GPS" featuring me, Teeka Tiwari, Costas Bocelli and occasionally, Ed Pawelec.

Please trade safely, use tight stop-losses, and don't fight the trend.  When investors are overly bullish, that is often the time when the fastest profits are made on the upside ... but also a precursor to a sharp sell-off.

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