Why Current Investor Sentiment Readings Should Make Bulls Nervous

Why Current Investor Sentiment Readings Should Make Bulls Nervous

Being Street Smart

by Sy Harding

Here’s What Investors Should Be Watching!

November 19, 2010.

The market is in what is usually its favorable season of November to May, when it typically makes most of its gains each year. But it hasn’t been that way so far.

Among other worries, analysts are concerned that the market’s consistent annual seasonality of ‘Sell in May and Go Away (until November1)’ has failed to work over the last two months. The market topped out on schedule in late April and was down 16% by July. This fall it began what is historically the worst three-month period of the year, August, September and October, with a big decline in August, which was the worst August in years. But then, usually negative September and October turned out to be just about the most positive two months of the year.

So can we be sure November, December, and January will follow their historical pattern of usually being the most positive months of the year? Or was the weakness that normally takes place in September and October postponed to November and December? November hasn’t started out well, with the S&P 500 down roughly 3% over the last two weeks.

So, analysts are watching potential support and resistance levels.

For instance, two weeks ago the S&P 500 had rallied all the way back to the level it reached at its April top. It has now pulled back from that potential resistance level, and in the process it broke below the previous support at its 21-day moving average for the first time since the rally began in early September.

The question is whether it can break back up through the resistance at that moving average and establish it as support again, or if the moving average will now become overhead resistance that prevents the market from making further progress.

Interesting enough, the market experienced a big triple-digit rally on Thursday that carried the S&P 500, Dow, and Nasdaq back up almost to their 21-day moving averages in one day. But the rally stopped just short of those resistance levels. So the question is still out there.

S&P 500 chart november 2010 moving averagesSource: StockCharts.com

Normally, market analysts would not be focused on such short-term considerations. But a situation is also in place that might have intermediate-term implications, thus making how the market deals with the short-term support and resistance levels more important.

SEC filings show that usually astute corporate insiders have been selling into the market strength of the last few months at a near record pace, even as investor groups that have a history of being wrong at market turning points (extremely bearish at market bottoms and extremely bullish at market tops) have taken the opposite position.

For instance, mutual funds have a history of holding high levels of cash at market bottoms and being fully invested at market tops, and they have stepped up their buying in the last two months. Bank of America/Merrill Lynch reported this week that its latest poll of large fund managers, conducted between November 5 and November 11, found their sentiment to be the most bullish since April, that they have invested just about all they can, now holding on average only 3.5% of their investors’ assets in cash reserves to meet potential redemptions, one of the lowest levels of cash on record.

The latest sentiment report by Investors Intelligence, which measures the sentiment of investment newsletters, shows 56.2% are bullish, only 20.2% bearish, the highest level of bullishness since December, 2007, which was a couple of months after the severe 2007-2009 bear market began.

And the weekly poll of its members by the American Association of Individual Investors, showed sentiment had reached 57.6% bullish last week, its highest level in a number of years, higher than just before the 2007 bull market top (54.6% bullish), higher than just before the top in January of this year (49.2%) and higher than just before the April top (48.5% bullish).

It plunged to only 40.0% bullish this week, which had some pundits saying, “Ah, that removes the risk from the investor sentiment side.”

But unfortunately that’s not how it usually works.

The market was down sharply last week and the first three days of this week. So sentiment would be expected to be less bullish this week. But once a warning level of bullishness has been reached, a return to lower levels doesn’t usually make any difference.

For instance, at the bull market top in 2007, bullishness reached 54.6% on October 11. The market had already topped out two days earlier. The next weekly reading on the AAII poll showed a drop to 41.9% bullish, and two weeks later to only 31.2% bullish. Those subsequent drops in bullishness were of no importance, the 2007-2009 bear market was underway.

Similarly, at the April top this year, the AAII poll reached its high of bullishness at 48.5% on April 15. It dropped to only 38.1% bullish the next week. But that was of no importance. The peak of bullishness had been reached. The market topped out into the April-July correction on April 23, a week after the high reading.

So, analysts are probably justified in watching to see if the market can recover and break out above the potential resistance at short-term 21-day moving averages again.

If not, and the potential top-out at the high two weeks ago remains in place, those high levels of bullish investor sentiment last week will take on more importance.

Sy Harding is editor of the Street Smart Report, and the free market blog,www.streetsmartpost.com.