Outside the Box: Crowd psychology supports a year-end rally in stocks

Last year around this time, stock investors were floating on Cloud 9. Not this year. In fact, some recent headlines have been gloomy.

From a contrarian perspective, are things bad enough to be good? Look at these headlines:

CNN: “Morgan Stanley: We are in a bear market”

CNBC: “Bear market is mauling stocks, says Jim Cramer”

Forbes: “The bear continues to drive this stock market”

Investopedia: “Every FAANG stock in bear market”

Read: Did the Fed’s Powell ‘light the fuse’ for a year-end stock-market rally?

Almost exactly a year ago, I wrote about the correlation between financial headlines and stocks. The article included a 10-second test and concluded that: “The risk of a correction is getting closer.”

While looking at headlines can be helpful, the focus of this article is actual investor-sentiment indicators, which allow us to gauge crowd psychology.

The premise of contrarian analysis is that the market tends to do the opposite of what most people expect. The key question therefore is: What do most investors expect? Or, what will the market have to do to separate the majority of investors from their money?

Investor sentiment

The chart below plots the following six sentiment indicators against the SP 500

SPX, +0.04%

:




1. CBOE SKEW Index (5-day simple moving average, or SMA)

2. CBOE Equity Put/Call Ratio (5-day SMA)

3. CBOE Volatility Index

VIX, +1.92%

4. Bullish exposure of National Association of Active Investment Managers (NAAIM)

5. Share of bullish advisers polled by Investors Intelligence (II)

6. Share of bullish investors polled by American Association of Individual Investors (AAIM)

The dashed gray and red lines allow for an easy comparison of current readings with the January/February 2018 and August/September 2015 corrections.

Conclusion

Investor sentiment, when combined with other indicators, allows for a short-term and a long-term conclusion:

1. Short-term: A large amount of investors is quite bearish, and a rally would burn those premature bears.

The Russell 2000

RUT, -0.05%

Nasdaq 100

NDX, -0.15%

 and Dow Jones Industrial Average

DJIA, -0.12%

 just carved out bullish divergences, which would allow for further gains (bullish Nasdaq divergence is shown here).

2. Longer-term: Although similarly bearish sentiment readings marked many of the lows seen in recent years, this correction might become deeper than any other correction we’ve seen in recent years.

This could translate into a year-end rally followed by a New Year hangover. This article includes a longer-term forward projection based on multiple indicators (including sentiment).

Simon Maierhofer is the founder of iSPYETF and publisher of the Profit Radar Report. He has appeared on CNBC and Fox News, and has been published in The Wall Street Journal, Barron’s, Forbes, Investors Business Daily and USA Today.

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