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Technical Tuesday - I’m Calling it - Here Comes a Rally

By Chris Rowe July 26, 2022 Facebook Logo Twitter Logo Email Logo LinkedIn Logo

Hi there…

In last Tuesday’s urgent conversation, I showed you why it was “do or die time” for the stock market. 

I told you we were seeing signs of demand coming back. There’s more to this story, and you need to know about it.

That’s because one key indicator (which we didn’t talk about last week) is saying we could soon see a rally off a major bottom.

This tool – the Investors Intelligence Sentiment Indicator – is wicked reliable and easy to understand. And right now it’s showing the kind of sentiment we rarely see.  What’s more, it’s the only leading technical indicator that we have.

I emphasize the “leading” nature of this indicator because most technical indicators are by their nature lagging indicators. They’re based on trends and reversals of trends, which depend on price action. That is, all lagging indicators are based on stuff (price) that’s already happened.

Sentiment, as a leading indicator, isn’t based on anything that’s already happened except for one thing – peoples’ mood (bullish or bearish). And mood is a kind of future forecaster. So the Sentiment indicator is based on what usually happens next.

Let’s look at the most current Sentiment indicator, and then I’ll tell you two ways to play this market based on what the indicator shows.

We’re actually going to see two views of sentiment. Again, they’re very easy to understand.

(Click any image to enlarge)

At the top of that image is the S&P 500. At the bottom is a picture of peoples’ moods. And when I say people, I mean professional independent investment advisors. 

We owe this picture to an unsung hero named John Gray

When I become king of the forest, Mr. Gray is getting a Nobel Prize, a Heisman Trophy, and any other awards I can throw his way. Because every day this man combs through more than a hundred investment newsletters, and other content put out by independent advisors, and he determines if their outlook/mood is bullish or bearish.

In the lower panel of the image, the blue line shows the percentage of advisors who’s sentiment (revealed through their actual writings to their actual clients) is bearish. The red line shows the percentage of advisors who’s sentiment is bullish. Simple, right?

Let’s see what this all means. But first, you should know that one reason this indicator is so robust and reliable is precisely because, crucially, Gray only looks at independent advisors. 

Because those advisors are independent, they’re not employed by or allied with any big institutions. They don’t have to “toe the party line” and say they’re bullish or bearish when they’re actually not. This is a huge advantage that’s baked into the Sentiment indicator.

What we’re interested in when we look at the Sentiment indicator is a general idea of the range, that is, the spread between bullish and bearish. The spread shows us whether or not we’re at an extreme level. 

So you don’t have to scroll back up, here’s that image again.

The dotted purple arrows show times when the range of the chart was very large. When bullish sentiment was at or nearing an extreme. The more bullish advisors there are (out of 100%) the fewer bearish advisors there are. This is why the spreads grow wider.

This indicator is most useful at the extremes. That’s because sentiment is a contrarian indicator. When sentiment is “too bullish” (when people are greedy) we want to start getting bearish (fearful).  And when sentiment is too bearish (fearful) we want to get bullish (greedy). 

With this indicator, we start approaching extreme bullishness (again, the red line) when the percentage of bullish advisors gets above around 55%. Right now we’re in a bear market, so we’re interested in the other extreme.

Another (perhaps easier) way to see the spread/range is to look at the difference between bullishness and bearishness.

I said earlier we’d look at two versions of the Sentiment indicator. Here’s the second one.

The top part shows the S&P. But the bottom part shows the difference between bullish and bearish. If 60% of advisors are bullish and only 20% are bearish, the difference is 40%.So a difference of 40 percentage points is a reading that suggests advisors are feeling very bullish - perhaps overly bullish. (Glance at the chart, above, to make this register, please. 

If 30% are bullish and 30% are bearish, the difference is 0%. Again, glance at the charts. 

So when the difference is low or if there’s more bears than bulls (a negative difference), the market is usually at or nearing an historic low. (And that’s what’s going on right now).  

So things get really interesting when we get below zero percent, below the black horizontal line on the chart. For that to happen, there must be more bearish sentiment than bullish sentiment. As you can see, that rarely happens, but it’s happening now and it's where things stand today.

Also, the further below the line we go, the more “overly bearish” sentiment there is in the market.  Again, this is a contrary indicator. This would be a “crowded trade” where if too many people think the same thing (like today’s bearishness), then the opposite is likely to happen (so higher prices are more likely at this juncture). 

On the chart above, the green circles and red arrows represent occasions over the past 20 years when bearish sentiment was at an extreme. I haven’t circled every occasion, but that doesn’t matter. 

To put things in real-world context and perspective, the red arrow (#3) is from March 2009, during the bear market that followed the credit crash of 2008. The green circle at the far right (#5) is the COVID-19 bottom in March of 2020.

The first green circle is from the summer of 2002. Sentiment was around negative 15. And here’s the S&P from around that time.

The highlighted area shows where the S&P gained 14.22% before giving back 8.44% and then rallying for an additional +15.34% gain.

The moral of the story is that even in a bear market, we can get a rally. And because, again, sentiment is contrarian, we usually want to get greedy when the world is fearful.

Green circle #2 is from April 2008, around the time of the credit crash. Again, sentiment was around negative 15. And here’s the S&P from back then.

The highlighted area shows where the S&P gained 8.60%. Again, sentiment was a reliable contrarian indicator.

Again, the red arrows show the depths of the bear market, from October 2008 to about April 2009. Here’s the S&P…

The decline in the bear market is obvious. But notice the black arrows. They show again how even in a bear market we see these opportunistic zigs and zags. From left to right, the three arrows represent short-term gains of +18.47%... +19.04%... and +23.41%.

There are two more green circles on our Sentiment chart, above, representing extreme readings. But because we’re running out of time (and I want to tell you how to play the current market) I won’t discuss them with you now.

Instead, why not look at the circles, determine their dates (you don’t have to be accurate to the day)... and then look at the S&P 500 on your trading platform. What happened next? What does that tell you about the market and the Sentiment indicator?

And I would love it if you dropped me an email with your answers!

OK…

Here’s that Sentiment chart once again.

You can see at the far right that sentiment is extremely bearish right now. History favors a move to the upside. That doesn’t mean the bear market is over. 

But you just saw how rallies off of extreme sentiment during bear markets can be significant.

So the big question remains. Are we gonna get a rally? Or are we gonna go lower first?

I think we’re going to get our rally.

So what should you do? I have two answers for you.

Answer #1: You can hedge by taking bearish positions in addition to bullish. In fact, at the beginning of the summer I made a video showing you how to play this “Declining Stage" bear market. That playbook involves playing both sides.

If what we said above seems a little confusing, or if you simply would rather have an easier solution, I recommend you go with answer number two.

Answer #2:  You can simply zoom in to a timeframe that’s so short – the level of those “zigs and zags” we saw earlier – that you actually won’t care if we’re in a bear market, a bull market, a sideways market… or whatever. 

The idea is that you make the time horizon its own small investing universe. Then, you play the upside or the downside, whichever short-term direction gives you the greatest odds of winning, given your new, narrow horizon.

This is the strategy that Costas Bocelli uses.  And this guy crushes in all markets!  He’s a genius.

Again, do that little "homework" I gave you (to compare the market to the remaining two green circles on the chart) and email me with your findings. 

Trade Safely,

Chris Rowe

Founder, True Market Insiders

 

 

 

 

"You see it in the price before you see it in the news."

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