Posted |

One of the hallmarks of stock market declines seen in what we call the "QE Era" has been the "V-Bottom." If one looks back at the declines seen since 2010, the vast majority of the corrections have traced out a "V" pattern on a chart as the emotional pullbacks have generally been met with enthusiastic buying once the selling subsides.

From my perch, the reason behind all the "V's" on the charts over the last 5 years has been the seemingly endless flow of freshly printed "QE cash," which, of course, needed to find a home somewhere. And since money has tended to go where it is "treated best" in the global marketplace, the U.S. stock and bond market wound up being the recipient of a lot of that new capital - especially during corrective phases when prices are "on sale."

As such, the "buy the dip" game has been pretty easy to play lately. One simply waits for traders and their computers to freak out over the crisis du jour and then start buying when things get ugly.

So, with lots of pundits, experts, and analysts currently fawning over the idea that the bottom was put in last week, the question now becomes, how does one tell when the emotional selling has ended?

This my dear readers, is why sentiment indicators exist - to help us identify when the market action has gotten so bad that it's good.

Here's the way this works. But first let me say that (a) the sentiment game is not easy as it is often more art than science and (b) I've spent many years studying an approach pioneered by Ned Davis - so I can't exactly take credit for the concepts we are about to review.

So let's get to it. If you are looking for a way to identify market bottoms (bottoms are much easier to identify than tops - which often take months and months to develop), you first want to capture data from all kinds of investors about how they are "feeling" about the current state of the market - i.e. whether they are bullish, bearish, or in between. You then plot the data on a chart and look for periods of extreme readings. Next - and this is the important part - you wait for an extreme reading to reverse before taking any action. And the vast majority of the time, this will help you identify when a contrarian stance can be taken.

A "Super Model" for Sentiment

The gang at Ned Davis Research Group create all kinds of sentiment indicators and models. However, I've become a big fan of their daily sentiment composite, which I call a "super model" due to the fact that it is a model of models and contains scores of indicators.

This model includes just about everything under the sun that can be considered an indicator of investor sentiment such as data from AAII, NAAIM, Sentix, Investors Intelligence, Hulbert, Rydex Funds, commercial traders, as well as models incorporating the VIX (domestic and international), SKEW, Put-Call Ratios, volume, breadth, etc.

The key is that the reading from this model reached a level deemed to be "extreme" last week. And history shows that unless things are about to get REALLY bad in the stock market, this is actually a good thing.

Take a look at the table below. Yes, there are a lot of numbers. But the bottom line is that after an extreme negative sentiment signal has been given, stock market returns are (a) usually positive in the ensuing 1, 2, 3, and 6 months and (b) the returns are significantly better than the average for the time periods.

The data from this model go back to 1996, so we are hypothetically looking nearly 20 years' worth of sentiment model readings. During that 20-year period, there would have been a total of 33 extreme negative readings. So, the idea is to go back and look at what happened to the market after a signal that sentiment had become extremely negative had been given.

In looking at the data, the first item of note is that one month after the sentiment reached an extremely negative reading, the stock market would have been higher the vast majority of the time - 82% to be exact.

In addition, the study shows the average return for the S&P 500 for all 33 cases one month after the signal was nearly 3.6%. And when you compare this to the return for all one-month periods of +0.7%, it is plain to see that there just might be something to this idea of looking for extreme sentiment readings.

I also wanted to look at how this type of signal would have functioned during more recent times - during the "QE Era." So in looking at the signals that would have occurred since 2010, we find that the market was higher one month after the signal 89% of the time and that the S&P sported an average gain that while below the 20-year average, was still nearly 5 times higher than the average for all one-month periods.

What's interesting to note is that during the QE Era, the returns were much more pedestrian two months after a signal. The market was higher only about half the time and the average returns were pretty much in line with the average for all two-month periods. Personally, I would attribute this to the market quickly become overbought during the ensuing rebounds.

However, the positive outperformance from the type of signal returns when looking out three and six months after the signal is flashed.

It could be argued that the sample size in the QE Era is too small and that the signals occurring since 2010 took place during a bullish period. While this is certainly true, the key point is that the returns for the S&P after a signal have been above average for the period studied, which is nearly 20 years.

The Bottom Line

From my perspective, the key is to recognize that (a) buying the dips has been a very successful approach for some time now and (b) sentiment indicators can help investors identify when the odds are in their favor in terms of putting capital to work.

While no one knows if the current decline is over, the sentiment model suggests that the odds favor stocks being higher one, two, three, and six months out. So, if an investor is looking to put money to work in either the market or their overall portfolio, now might be a good time to get serious about doing so.

Publishing Note: I am traveling for the next week and a half and will publish reports as my schedule permits.

Turning to This Morning

Things are fairly quiet for a change this morning. The primary stories include no RRR cut in China and oil moving lower. The PBoC is using liquidity injections instead of a rate cut in China for fears that another reduction in the RRR would put further pressure on the yuan. On the oil front, after a 10% rally last week crude is moving down this morning on renewed supply concerns. Iraq's oil ministry said today that the country's oil production hit a record in December on the back of output increases and Saudi Aramco also said it has not reduced investment capacity. Finally, oil traders note that Indonesia’s OPEC governor said only one OPEC member supports an emergency meeting. In Europe, stocks are waffling around break even and here in the U.S., futures point to a slightly lower open on Wall Street.

Today's Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell...

Major Foreign Markets:
    Japan: +0.90%
    Hong Kong: +1.36%
    Shanghai: +0.77%
    London: +0.02%
    Germany: -0.05%
    France: -0.13%
    Italy: -0.91%
    Spain: -0.87%

Crude Oil Futures: -$0.99 to $31.20

Gold: +$9.90 at $1106.20

Dollar: lower against the yen and pound, higher vs. euro

10-Year Bond Yield: Currently trading at 2.033%

Stock Indices in U.S. (relative to fair value):
    S&P 500: -2.10
    Dow Jones Industrial Average: -34
    NASDAQ Composite: -8.57

Thought For The Day:

Kind words can be short and easy to speak, but their echoes are truly endless. -Mother Theresa

Here's wishing you green screens and all the best for a great day,

David D. Moenning
Founder and Chief Investment Strategist
Heritage Capital Research

Current Market Drivers

We strive to identify the driving forces behind the market action on a daily basis. The thinking is that if we can both identify and understand why stocks are doing what they are doing on a short-term basis; we are not likely to be surprised/blind-sided by a big move. Listed below are what we believe to be the driving forces of the current market (Listed in order of importance).

      1. The State of the Oil Crisis
      2. The State of China's Renminbi
      3. The State of Global Central Bank Policy
      4. The State of the Earnings Season

The State of the Trend

We believe it is important to analyze the market using multiple time-frames. We define short-term as 3 days to 3 weeks, intermediate-term as 3 weeks to 6 months, and long-term as 6 months or more. Below are our current ratings of the three primary trends:

Short-Term Trend: Negative
(Chart below is S&P 500 daily over past 1 month)

Intermediate-Term Trend: Negative
(Chart below is S&P 500 daily over past 6 months)

Long-Term Trend: Neutral
(Chart below is S&P 500 daily over past 2 years)

Key Technical Areas:

Traders as well as computerized algorithms are generally keenly aware of the important technical levels on the charts from a short-term basis. Below are the levels we deem important to watch today:

  • Key Near-Term Support Zone(s) for S&P 500: 1850
  • Key Near-Term Resistance Zone(s): 1950-1980

The State of the Tape

Momentum indicators are designed to tell us about the technical health of a trend - I.E. if there is any "oomph" behind the move. Below are a handful of our favorite indicators relating to the market's "mo"...

  • Trend and Breadth Confirmation Indicator (Short-Term): Neutral
  • Price Thrust Indicator: Negative
  • Volume Thrust Indicator(NASDAQ): Negative
  • Breadth Thrust Indicator (NASDAQ): Negative
  • Short-Term Volume Relationship: Negative
  • Technical Health of 100+ Industry Groups: Negative

The Early Warning Indicators

Markets travel in cycles. Thus we must constantly be on the lookout for changes in the direction of the trend. Looking at market sentiment and the overbought/sold conditions can provide "early warning signs" that a trend change may be near.

  • S&P 500 Overbought/Oversold Conditions:
          - Short-Term: Oversold
          - Intermediate-Term: Oversold
  • Market Sentiment: Our primary sentiment model is Positive

The State of the Market Environment

One of the keys to long-term success in the stock market is stay in tune with the market's "big picture" environment in terms of risk versus reward.

  • Weekly Market Environment Model Reading: Negative

Indicator Explanations

Trend and Breadth Confirmation Indicator (Short-Term) Explained: History shows the most reliable market moves tend to occur when the breadth indices are in gear with the major market averages. When the breadth measures diverge, investors should take note that a trend reversal may be at hand. This indicator incorporates an All-Cap Dollar Weighted Equity Series and A/D Line. From 1998, when the A/D line is above its 5-day smoothing and the All-Cap Equal Weighted Equity Series is above its 25-day smoothing, the equity index has gained at a rate of +32.5% per year. When one of the indicators is above its smoothing, the equity index has gained at a rate of +13.3% per year. And when both are below, the equity index has lost +23.6% per year.

Price Thrust Indicator Explained: This indicator measures the 3-day rate of change of the Value Line Composite relative to the standard deviation of the 30-day average. When the Value Line's 3-day rate of change have moved above 0.5 standard deviation of the 30-day average ROC, a "thrust" occurs and since 2000, the Value Line Composite has gained ground at a rate of +20.6% per year. When the indicator is below 0.5 standard deviation of the 30-day, the Value Line has lost ground at a rate of -10.0% per year. And when neutral, the Value Line has gained at a rate of +5.9% per year.

Volume Thrust Indicator Explained: This indicator uses NASDAQ volume data to indicate bullish and bearish conditions for the NASDAQ Composite Index. The indicator plots the ratio of the 10-day total of NASDAQ daily advancing volume (i.e., the total volume traded in stocks which rose in price each day) to the 10-day total of daily declining volume (volume traded in stocks which fell each day). This ratio indicates when advancing stocks are attracting the majority of the volume (readings above 1.0) and when declining stocks are seeing the heaviest trading (readings below 1.0). This indicator thus supports the case that a rising market supported by heavier volume in the advancing issues tends to be the most bullish condition, while a declining market with downside volume dominating confirms bearish conditions. When in a positive mode, the NASDAQ Composite has gained at a rate of +38.3% per year, When neutral, the NASDAQ has gained at a rate of +13.3% per year. And when negative, the NASDAQ has lost at a rate of -8.5% per year.

Breadth Thrust Indicator Explained: This indicator uses the number of NASDAQ-listed stocks advancing and declining to indicate bullish or bearish breadth conditions for the NASDAQ Composite. The indicator plots the ratio of the 10-day total of the number of stocks rising on the NASDAQ each day to the 10-day total of the number of stocks declining each day. Using 10-day totals smooths the random daily fluctuations and gives indications on an intermediate-term basis. As expected, the NASDAQ Composite performs much better when the 10-day A/D ratio is high (strong breadth) and worse when the indicator is in its lower mode (weak breadth). The most bullish conditions for the NASDAQ when the 10-day A/D indicator is not only high, but has recently posted an extreme high reading and thus indicated a thrust of upside momentum. Bearish conditions are confirmed when the indicator is low and has recently signaled a downside breadth thrust. In positive mode, the NASDAQ has gained at a rate of +22.1% per year since 1981. In a neutral mode, the NASDAQ has gained at a rate of +14.5% per year. And when in a negative mode, the NASDAQ has lost at a rate of -6.4% per year.

Bull/Bear Volume Relationship Explained: This indicator plots both "supply" and "demand" volume lines. When the Demand Volume line is above the Supply Volume line, the indicator is bullish. From 1981, the stock market has gained at an average annual rate of +11.7% per year when in a bullish mode. When the Demand Volume line is below the Supply Volume line, the indicator is bearish. When the indicator has been bearish, the market has lost ground at a rate of -6.1% per year.

Technical Health of 100 Industry Groups Explained: Designed to provide a reading on the technical health of the overall market, this indicator takes the technical temperature of more than 100 industry sectors each week. Looking back to early 1980, when the model is rated as "positive," the S&P has averaged returns in excess of 23% per year. When the model carries a "neutral" reading, the S&P has returned over 11% per year. But when the model is rated "negative," stocks fall by more than -13% a year on average.

Weekly State of the Market Model Reading Explained:Different market environments require different investing strategies. To help us identify the current environment, we look to our longer-term State of the Market Model. This model is designed to tell us when risk factors are high, low, or uncertain. In short, this longer-term oriented, weekly model tells us whether the odds favor the bulls, bears, or neither team.


The opinions and forecasts expressed herein are those of Mr. David Moenning and may not actually come to pass. Mr. Moenning's opinions and viewpoints regarding the future of the markets should not be construed as recommendations. The analysis and information in this report is for informational purposes only. No part of the material presented in this report is intended as an investment recommendation or investment advice. Neither the information nor any opinion expressed constitutes a solicitation to purchase or sell securities or any investment program.

Any investment decisions must in all cases be made by the reader or by his or her investment adviser. Do NOT ever purchase any security without doing sufficient research. There is no guarantee that the investment objectives outlined will actually come to pass. All opinions expressed herein are subject to change without notice. Neither the editor, employees, nor any of their affiliates shall have any liability for any loss sustained by anyone who has relied on the information provided.

The analysis provided is based on both technical and fundamental research and is provided "as is" without warranty of any kind, either expressed or implied. Although the information contained is derived from sources which are believed to be reliable, they cannot be guaranteed.

David D. Moenning is an investment adviser representative of Sowell Management Services, a registered investment advisor. For a complete description of investment risks, fees and services, review the firm brochure (ADV Part 2) which is available by contacting Sowell. Sowell is not registered as a broker-dealer.

Employees and affiliates of Sowell may at times have positions in the securities referred to and may make purchases or sales of these securities while publications are in circulation. Positions may change at any time.

Investments in equities carry an inherent element of risk including the potential for significant loss of principal. Past performance is not an indication of future results.

Advisory services are offered through Sowell Management Services.