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The Nature Sentiment In Bullish & Bearish Markets at Trader’s Narrative

Way back in a January sentiment overview, I mentioned that the AAII bearish sentiment had reached a shocking 59% bearish level with bulls only 20%. According to historical data, this is very bullish because whenever the AAII bears go above 50% this is what happens:

S&P 500 SPX and AAII sentiment 1988-2007

Since 26 weeks have gone by, here is a chart showing what actually happened:

sentiment aaii bearish 50 plus not enough

Since the extreme sentiment caught everyone’s notice, the stock market totally ignored it and went underwater. The only exception was when in mid-May it resurfaced for a blink of an eye to break even, only to descend into murky depths again.

The S&P 500 Index (SPX) finished down 11.5%. Not a resounding vote of confidence for sentiment. But that is the nebulous nature of sentiment. Trying to get a quantifiable edge from it is like trying to nail jello to the wall. So what happened?

Take a look at my previous analysis on bearish sentiment during a bear market. As you’ll see in the graphs in that article, there was a long lag between the occurrence of extremes in bearish sentiment and a lasting market bottom.

The nature of extremely negative sentiment is that it has a lag bear markets, while it doesn’t in bull markets. To see another example, consider that in the rolling 52-week time between 1990 -1991 the AAII gave 14 separate instances of bearish sentiment above 50%. Pull out your very long term charts and you’ll see the lag there. In contrast, consider the summer of 2006 where the market quickly bounced back.

Also, as I keep repeating, sentiment is only one leg of the table. The other three are technical analysis, fundamental analysis and fund flows.

If you haven’t already, make sure you check out the “Best Of” section for more interesting articles about sentiment, technical analysis and much more.

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3 Responses to “The Nature Sentiment In Bullish & Bearish Markets”  

  1. 1 BourningMarkets

    In bullish markets, forget the bullish readings, but long the bearish ones.
    In bearish markets, foget the bearish readings. but short the bullish ones.

  2. 2 Babak

    You hit the nail on the head… one thing though, how do you tell them apart?

  3. 3 BourningMarkets

    Well, as any simple rule, this one is easier said than done. But useful, however. In fact, I realized this when reading your post in “The best of” about sentiment in bearish markets. The rest is more or less obvious:

    The principle behind seems to me much the same as in any oscillator. Let’s say you’re in a bullish trend and your stochastic crosses over 80, so you decide to short. You’d better be careful, Flanagan. You’re risking a “bullish swang sing”, i.e., a final buying panic. At the very least, rise your threshold. The opposite is true in the bearish case: when going long in oversold market, you’re risking the final selling panic leg. If not panics, you risk time: the market can stand in a long trendish lateral (bad for bought options).

    About your question, how do you tell them apart?, if you ask about the sentiment readings, well, it is anyone’s task to determine thresholds through visual inspection. In Equity p/c ratio, I have these conventional orientative thresholds as horizontal lines:
    0,36 Very overbought
    0,50 Overbought
    0,78 Oversold
    0,92 Very oversold

    But they are just a quick reference. For example, at this moment, the Equity p/c chart suggest that 0,6 is a good place to look for shorts. The chart since 2006 also illustrates very well the abovementioned principle. Only a brief touch to the oversold threshold used to be enough to trigger a good bullish reaction. Then you compare that behavior with the awful one in Q1/08, where multiple very oversold readings were needed before a rebound was in order.

    As usual, the points transition from bullish to bearish and viceversa is not easy and you’ll need other tool-s.

    i.e., the only “tool” that a friend of mine and investor here in Spain needed to know to tell it was what was that messy “Countrywide” he had heard something about in the news, back in mid-07. He called me to ask, and soon after I began to explain, he almost hanged the phone to call inmediatly his broker, mumbling about “bad business, read Galbraith about the 29, it started with a real state crisis, bad business” and the like.

    And he was timely right, indeed. Since then, all we have learned about the letter soup (CDOs, ARMs, etc etc and, specially, CDS) has only confirmed and increased our alarm. While the “White Knights” have now more resources and a more proactive attitude than in 29, the problem is also a monster leveraged credit bubble. Finantial sofistications. The Big Deleveraging is proceeding (check Mish Shedlock’s, Roubini’s RGE Monitor, etc). And we’d better pray that CDSs system don’t crash. Wouldn’t funny.

    Hoping this is useful, as for sure your blog is. Saludos desde Madrid.

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