Trader’s Narrative

John, from Tale of the Tape, asks a very interesting question regarding the nature of sentiment during a bear market. He wonders whether high bearish sentiment is a bullish signal during both bear and bull markets.

Well, lets examine the bear market that began in early 2000 by looking at the S&P 500 index and the absolute readings of AAII bearish sentiment that accompanied it:

Now, be mindful that the dates for the survey and the weekly candles don’t match exactly. What I’ve done is to round ahead to the next candle/week. So for example, if the survey date is May 12th and there are two candles with start dates May 8th and May 15th, I put the “sentiment” dot on May 15th’s candle. Capisce? The result is that in some instances it may appear that sentiment was ‘off’ or ‘late’ in signalling a rally… where it wasn’t really.

Some observations from this first phase of the bear market:

• first heavy bearish sentiment was waay off for the S&P (much better for Nasdaq)
• ditto for the lighter one that came right after it
• sentiment didn’t get bearish again for a long time
• but when it did, it was a great signal for a rally in March 2001
• in early stages of a cyclical bear market, sentiment can be a great tell
• but only after the market has seen a significant decline and/or correction

And the next phase of the bear from 2002 onward:

Wow! The graph lights up like a Christmas tree:

bearish sentiment went haywire approaching 1000 - right at previous support
• naturally, a lot of people became bearish as the index revisited its lows
• bearish sentiment accompanied the index’s plunge!
• clusters of major bearish sentiment can actually be dangerous!
• it is much better to get a lone ‘dot’ than a crowd of them (see first graph)
• you need severe and sustained bearish sentiment for a significant bottom
• bearish sentiment can ‘wash out’ - no real bearish reading after March 13, 2003

But remember that sentiment, especially only one measure of it such as AAII, should never be used as a tell in isolation. Sentiment as a contrarian measure is useful, but it must be combined with other tools to round out a picture.