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Is Sentiment Becoming A Problem? image

Good Morning. After the issue of stock market valuations, investor sentiment may be one of the most misunderstood and misused indicators available today. The issue is simple. Nobody thinks they are part of the herd. No one wants to be the "greater fool." Everyone knows that bubbles don't end well. And as such, everyone wants to be a contrarian. But by the very definition of the term, this just isn't possible, is it?

Some investors believe that just trading opposite of whatever the market is doing that day makes them a contrarian (a very popular TheStreet author who has sworn off of social media comes to mind). Others, thinking that "the crowd" is always wrong, never want to hold positions that they consider popular. And still others feel that every time sentiment indicators reach either bullish or bearish extremes, it is time to go the other way.

To be sure, there are times when any or all of the above can make for an effective trade. But frankly, the idea of being a contrarian has, in my humble opinion, become entirely too popular. And as a strategy for long-term success in the stock market, trying to be contrary for the sake of being contrary is just plain foolish.

In reality, most investors don't have the internal fortitude to be a true contrarian. Attempting to truly run against the crowd means that one will be wrong for long periods of time before the position pays off (if the position pays off). John Paulson's short against the housing market (courtesy of Goldman Sachs) was just such an example. Yes, Mr. Paulson made "the trade of the century" and made billions. But did you know that he also was at least a couple YEARS early and almost went bankrupt in the process?

Another example would be the current stock market rally, which may be one of the most hated in history. Many of the stock market bears cling to the idea that they have not been "wrong" by sitting on the sidelines (or worse) for the past ten months. No, they are merely running contrary to a market that, in their opinion, has lost its mind. However, unless stocks crash in the near term and head back to Dow 12,500 in a hurry, missing out on the 25 percent gain seen since last November hasn't been admirable - it's just been wrong.

But I digress. Many of the glass-is-at-least-half-empty crowd also point to the current stock market sentiment indicators (the Investor's Intelligence and AAII data for example) as reasons to be negative on the outlook for the market. Our friends in fur opine that optimism is high and that there is entirely too much complacency today for stocks to have any real potential. As such, the thinking is the only way the indices can go is down.

However, history shows that high levels of optimism are not themselves triggers of bear markets or severe corrections. Remember, market trends can and often do last much longer than even the uber-optimists anticipate. Also, it is vital to recognize that timing counts in this game. So yes, excessive optimism can and often does lead to near-term pull-backs, garden-variety corrections, and/or what I like to call "sloppy periods." But the key is to understand that optimism must reach EXTREME levels and then reverse before the situation becomes really dangerous for investors.

In looking back at market history, it becomes clear that when sentiment reaches extreme levels it can indeed pay to be a contrarian. However, the problem is that the definition of extreme can vary widely in different market environments. For this reason, we look at several different sentiment indicators and models in order to get a handle on the degree of optimism/pessimism in the market. In short, we believe that you need to take a "weight of the evidence" approach to this subject.

What Are The Indicators Saying Now?

So, what are our models telling us now, you ask? One model that incorporates Investors Intelligence, AAII, CBOE Put/Call ratios, Rydex Funds assets, and sentiment of MBH Commodity Advisors is currently in the negative zone. However, this indicator was much higher (meaning that optimism was stronger) in April/May than it is now. But, this indicator is still in the negative category.

Another model (my personal favorite), which includes over 20 measures of investor sentiment, has an impressive record of signals over the last 20 years. When the model suggests that sentiment is excessively optimistic, the S&P has lost ground at the rate of 11 percent per year. When the model is neutral, the S&P has gained at an annual rate of 7.8 percent. And when the model says sentiment is extremely pessimistic, stocks have surged at a rate of nearly 27 percent per year. Thus, when this model gives a signal, we sit up and listen.

Because of the disparity of returns seen between the various zones of this indicator, we include it in our Market Environment Model. The idea is that when things become overly optimistic, this model will become more negative and push the overall reading of the environment model lower. Currently, the reading is "high neutral" and close to crossing over into negative territory. But while many will argue that optimism may be "high," our objective model suggests that it isn't time to become a contrarian just yet.

The key takeaway from this morning's missive is just that. Although complacency may indeed be high and some of our indicators do fall in the extreme optimism category, our favorite models are not yet in the danger zone. This does NOT mean that stocks will head higher from here. It simply means that our sentiment indicator is flashing a yellow light at the present time.

Turning to this morning... Perhaps the best summary of the current stock market is it's a Friday in August with the major indices stuck in a trading range. Data out of China was mostly upbeat but worries linger about the state of the world's second biggest economy. European bourses are mixed in uneventful trading. And as one might expect, with no economic data due out before the bell, U.S. futures are lower at the present time.

Positions in stocks mentioned: none

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