So far in 2014, the action in the stock market has been fairly sloppy. Despite the traditional strong seasonality (which ends shortly by the way) and the flow of new money that tends to occur at the beginning of a new year, there has been a great deal of intraday selling taking place this year.

Granted, the relentless sell programs have ultimately been met with buying and as such, the indices have managed to levitate thus far. However, there has been enough intraday weakness that we're on the lookout for a change to what has been a clear-cut bullish environment.

What's Causing All the Selling?

The sloppy action is likely due to the cross currents in market as there are concerns about the Fed accelerating the taper, waning earnings growth, the age of the bull market, and valuations becoming stretched. Therefore, it looks like the self-proclaimed masters of the universe have decided to do some selling each day so far in 2014 ('cause it worked out so well for them in 2013!).

However, at this stage of the game, the bottom line is we are not ready to declare that a change in environment has occurred. No, we would prefer to wait for some additional economic data as well as the message from current earnings season. Therefore, this is probably good time to continue our review of the state of our market models or what we like to call, the "market math."

Today, we'll look in on the state of market sentiment and tomorrow we'll finish up with a review of valuations.

External Factors: Sentiment

Stock market sentiment may be one of the most misunderstood indicators out there. In the old days - back before computers when stock market analysts drew trendlines with a ruler and the calculation of a moving average involved a legal pad, a pencil, and a calculator - being a "contrarian" was something unique. Back then, there were a handful of managers who knew that going contrary to the crowd was an easy way to make money.

But as happens with just about any market indicator or strategy over time, being a contrarian has become extremely popular. Nowadays, everyone wants to be a contrarian because "the crowd" is viewed as being the "dumb money." Yet by definition, this simply isn't possible. Remember, everyone can't be a contrarian! So, since every trader looks at sentiment indicators on a weekly basis, is it time to abandon the idea of contrary opinion?

Using Sentiment Indicators The Right Way

If you use investor sentiment in a traditional fashion, yes, it is probably a good idea to toss these indicators aside as they have simply become too popular. However, there is a wrinkle that can be applied to the sentiment game that can make these indicators a very valuable tool in your analysis arsenal.

The most common application of investor sentiment data is to look for the indicators to become either overly positive or overly negative - then become a "contrarian." However, there is a better way.

Strong Sentiment Readings Aren't Bad

Currently, lots of folks are crying wolf about the risk in the stock market due to the fact that investor sentiment has become quite positive. But, it is vital to understand that positive sentiment in and of itself, isn't bad. No, it's when sentiment reaches an extreme level and then (and this is the important part) reverses that it can pay to become a contrarian.

Each week, at StateoftheMarkets.com, we review one of our favorite long-term sentiment indicators that utilizes the Investor's Intelligence data. Over the years, this indicator has done a great job of warning investors that things are getting frothy. Oh, and this indicators is currently on a sell signal.

However, as we've stated a time or two in this series, relying on any one indicator can be problematic. As such, we prefer to put together a "tree of indicators" to give us the true picture of the area under review. And if you've been reading this series from the beginning, it won't surprise you to learn that we utilize combination of indicators, or models, in order to analyze market sentiment.

The Best Way To Use Sentiment Indicators

Before we get to the make-up of the model, the performance and the current reading, it is important to recognize that there is one major problem with sentiment indicators. You see, since bull markets have a tendency to run farther and last longer than almost anyone can imagine, the warning flags waved by sentiment indicators can oftentimes be early - sometimes VERY early.

Therefore, one of the best uses of sentiment indicators is to look at them as a warning flag, or as an alert that risk levels in the market are rising.

The key here is that when sentiment becomes extremely bullish and has been so for a long period of time, this indicates that anyone that wanted to invest in stocks has had the opportunity to do so. And if everyone is jumping up and down about how great the outlook is for the market, it means that stocks are vulnerable to disappointment.

So, when something bad finally comes along (and it always does) to trigger some selling, the market tends to experience a "whoosh" lower when sentiment is extremely positive. Therefore, it can pay to be on the lookout for that negative trigger whenever sentiment reaches an extreme.

What Are The Models Saying Now?

Our favorite sentiment indicator is, not surprisingly, a model of models. This means the model itself is made up of other models (in this case, a total of 7 separate models are used) and each independent model is comprised of multiple indicators.

Since 1982, when the sentiment model has signaled that the mood in the market is too frothy, the S&P 500 has lost ground at a rate of -16 percent per year. And when the model suggests that the outlooks is overly dour, the S&P has rocketed higher at annual rate of +36 percent. So, needless to say, we think this is an indicator that bears watching (pun intended) especially when it is flashing a red light.

So what is the indicator saying now, you ask? The sentiment model is red. No, make that bright red. In fact, every one of the sentiment models we follow is negative at this time.

The bottom line? While stocks may continue to amaze and astound to the upside, it just might be time to think about being a contrarian.

Positions in stocks mentioned: none

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