Sentiment Warning Signal Flashing Red – Again

Many traders use technical and/or fundamental data, but few traders have discovered the unique benefits of using sentiment data in their investment process. Sentiment data attempts to quantify the emotional mood of investors and traders and can be used as a very effective contra-indicator. When traders are complacent and overly bullish, markets tend to pull back. Conversely, when traders panic and emotions are running high, this often indicates a potential bottom and an attractive buying opportunity. The following article presents a unique and troubling sentiment warning signal from a recent proprietary research report from SentimenTrader.

SentimenTrader Research Study

I have a paid subscription to SentimenTrader, which supplies data that I use in several of my algorithmic trading strategies, but I am not otherwise affiliated with SentimenTrader.  At the end of January, SentimenTrader published an interesting proprietary research study that they have allowed me to share on Trader Edge. It is a representative example of how to use market sentiment and it generated a unique warning signal that is not reflected in other data.

The table in Figure 1 below documents the performance of the S&P 500 index when the index closed at a 12-month high, then declined for two consecutive months, and the Investor's Intelligence Bull Ratio remained above 60%. The data from the table covers the period from 1969 through the present. As you can see from the table, this sequence of events is unusual and has only happened 19 times in the last 46 years.

Normally, when the S&P 500 pulls back for two consecutive months from a 12-month high, investors would have begun to become concerned and head for the exits, especially when bombarded by a steady stream of bad news:

  1. the prospect of the Fed increasing short-term interest rates in 2015
  2. the eventual liquidation of the unprecedented Fed balance sheet
  3. evidence of economic weakness in Japan, Europe, and China,
  4. the startling rise of ISIS,
  5. renewed Russian aggression and expansion in Ukraine,
  6. the rapid decline in oil prices, destabilizing many emerging market economies,
  7. evidence of deflationary pressures, and
  8. the renewed risk of a Greek default & Euro exit

Following two consecutive months of declines, market sentiment would normally be negative. Instead, on 01-29-2015 the II Bull Ratio was a euphoric 76.5%. In similar circumstances, the table only shows three readings higher than 76.5%, all of which occurred in 1976. This is a highly unusual and overly complacent sentiment reading.

In that context, let's look at the table in Figure 1 below. The date of the signal and the II Bull Ratio are presented in the first two columns at the left-side of the table.  The next five columns provide the returns of the S&P 500 index over the subsequent 1 Month, 2 Months, 3 Months, 6 Months, and 1 Year. The data are provided for all 18 historical observations.

Summary information is provided at the bottom of the table for each of the return periods. The first summary row represents the median returns for all 18 previous historical signals. The next row provides the periodic S&P 500 return data for all dates. In other words, what were the median 1-Month, 2-Month, 3-Month, 6-Month, and 1-Year S&P 500 returns from 1969 to 2015? These values are directly comparable. If an II Bull Ratio of over 60% occurred after two consecutive monthly declines from a 12-month high, then we would expect the median signal performance to be below the performance on "All Days," which was the case for every time period.

The next two rows note the number of up and down observations (out of 18), but the last row is the most meaningful. The last row in the table represents the statistical significance of the returns for each performance period. As noted by SentimenTrader, values above 95% are statistically significant and "the higher the value, the more robust the result."

Figure 1: SentimenTrader II Bull Ratio 01-29-2015

Figure 1: SentimenTrader II Bull Ratio 01-29-2015

Intermediate and Long-Term Warning Signal

The red box highlights the S&P performance in the 1 month, 6 months, and 1 year following the research study signal. In every case, the median signal returns for the 18 historical observations were negative. This is highly unusual. As you can see from row two, equity returns have had a significant positive historical return bias, earning returns of 1.0%, 4.4%, and 9.4% for 1-month, 6-month, and 1-year periods respectively.

Contrastingly, the median signal returns for 1-months, 6-months, and 12-months were all negative and the median 1-year return of -5.0% was 14.4% below the "All Days" one year return. The "Relevance" or statistical significance levels were 96%, 96%, and 100% for the 1-month, 6-month, and 12-month periods respectively. In other words, the near-term and long-term study results are highly significant and decidedly bearish.

Conclusion

We should never read too much into any one research study, but we should never ignore statistically significant results either. Economic indicators are not currently consistent with a recessionary environment, although the risk of a recession has increased recently. In this environment, overly euphoric market sentiment after two consecutive monthly declines from a 12-month high in the S&P 500 is not encouraging.

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About Brian Johnson

I have been an investment professional for over 30 years. I worked as a fixed income portfolio manager, personally managing over $13 billion in assets for institutional clients. I was also the President of a financial consulting and software development firm, developing artificial intelligence based forecasting and risk management systems for institutional investment managers. I am now a full-time proprietary trader in options, futures, stocks, and ETFs using both algorithmic and discretionary trading strategies. In addition to my professional investment experience, I designed and taught courses in financial derivatives for both MBA and undergraduate business programs on a part-time basis for a number of years.
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One Response to Sentiment Warning Signal Flashing Red – Again

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