S&P 500 Index 1846
By Steve Blumenthal
February 26, 2014
Investor Sentiment has quickly moved back to the Extreme Optimism zone (as measured by the NDR Crowd Sentiment Poll) and the S&P 500 Index is challenging the all time price high.
We are in an overbought, over believed and overvalued market environment. I continue to recommend that hedges be put in place to protect your long-term focused equity portfolio exposure. Market risk remains high.
This week I thought I’d highlight yet another sentiment chart. I remember years ago subscribing to over 15 different stock market newsletters. I got twisted around by the varying views and opinions and didn’t know what to believe. It is a bit that way when you watch CNBC every day. As you probably know by now, investor sentiment plays a key role in identifying points of extreme market risk.
So just what are all of those newsletters saying today? This week I focus on data from Investors Intelligence, which sums up the independent forecasts from 130 different stock market newsletters.
This next chart shows the Dow Jones Industrial Average (DJIA) in the upper clip and an indicator based on data from Investors Intelligence in the lower clip.
- This from NDR explaining the concept: The chart is centered on the concept that the stock market tends to be a manifestation of group psychology in motion, as highs coincide with extreme group enthusiasm and lows coincide with excessive crowd fear. Such information can be useful at extremes in opinion, because at those extremes, the stock market majority is usually wrong. Almost by definition, a top in the market is the point of maximum optimism and a bottom is the point of maximum pessimism.
- The indicator in the lower clip is calculated by taking the ratio of the bulls to the total of its bulls plus bears from the various newsletter opinions. As shown in the bottom clip, excessive optimism is evident when the sentiment indicator moves above the upper bracket. Then, when the sentiment indicator drops below the upper bracket, a sell signal is generated since this provides confirming evidence that an extreme has been reached.
- Excessive pessimism is evident when the sentiment indicator drops below the lower bracket and then when the sentiment indicator moves above the lower bracket, a buy signal is generated since again this provides confirmation that an extreme has been reached. The results generated from testing this model are shown in the upper left hand corner of the chart.
If you are a quant geek like me, this chart shows 32 trades since 1970. 94% of those trades have been positive. I believe sentiment continues to be a valuable measurement tool to implement a well thought-out risk management approach as it relates to your long-term focused equity portfolio exposure.
The idea is to go against the crowd (hedge and unhedge) at points of extreme market opinion. The results from this indicator are impressive. It currently suggests a hedge or sell and move to cash. I favor hedging.
While long-term portfolio exposure to equities is vital to your clients’ long-term investment success, it is the bear market corrections that can shake them from their plan. Think 2002 and 2008. The real life emotional experience causes far too many investors to chase in and chase out at just the wrong times. I also believe that this level of portfolio attention can separate you from most other advisors in the business.
When the entire crowd is on one side of the fence, the wise investor is usually better off being on the other side. Unfortunately, when sentiment is extremely bullish, that is most likely the time when you are getting the call from a client saying he wants to go all in. Historical testing has shown that healthy gains can be achieved by staying in line with the crowd until sentiment reaches an extreme and then reverses, at which time it pays to take a contrary stance. That, I imagine, is the case for you today.
Of course, there are other ways to enhance and broaden portfolio exposure. Tactical is an important component as are other diverse risk streams yet this Trade Signals focuses on equity risk protection and in this regard, I remain in the “it simply makes sense to hedge” camp. In the below section titled Cyclical Equity Market Trend Charts – Both Trend Charts Remain Bullish of this piece, I have included links to further reading on hedging approaches.
Included in this week’s update (the usual weekly charts):
- Sentiment Charts – Crowd Sentiment is Extremely Optimistic: Hedge
- Cyclical Equity Market Trend Charts – Both Trend Charts Remain Bullish
- Provided are several links to learn more about the use of options to hedge
Investment Sentiment charts 2-25-2014:
Sentiment Chart 1 – NDR Crowd Sentiment Poll – Extreme Optimism:
We have quickly moved back to Extreme Optimism (Bearish) in this chart. Investor sentiment most recently peaked at 73.9. This is the second highest reading ever recorded – data 1995 to present. I continue to favor hedging long-term equity exposure until extreme pessimism is reached.
If you are a new reader, the gray area highlights the historical market performance when Investor Sentiment, as measured by Ned Davis Research, moves into the Extreme Optimism (Bearish) Zone (above the dotted black line or a reading of 66).
Sentiment Chart 2 – NDR Daily Trading Sentiment Composite – Neutral.
Just a Few Points Away from a Record High
While I favor the Crowd Sentiment data, I also look at a few other sentiment charts each week. The following Investors Intelligence Survey of Advisory Services shows the most optimism since 1987 (NOT A TYPO).
As for the major cyclical trend for equities, the trend remains higher. Here are two charts I watch each week:
Cyclical Equity Market Trend Charts – Both Trend Charts Remain Bullish
Cyclical Trend Chart 1 – 13/34-week EMA – The cyclical bull market’s uptrend remains in place. Note the blue 13-week EMA line remains above the red 34-week EMA line. Also note how well this simple, tactical trend indicator has historically captured the cyclical bull and bear market trends. Signals occur when the lines cross.
Cyclical Trend Chart 2 – The Big Mo Multi-Cap Tape Composite continues to signal a bullish uptrend for the market. Note the 84.6% Profitable Long Trades and the Gain/Annum when “Bullish” investing in the S&P 500 Index and the “Switch” to cash on Bearish readings. While no process is perfect, this is a chart I have favored for many years. Keep an eye on Big Mo.
Provided are several links to learn more about the use of options:
For hedging, I favor a collared option approach (writing out of the money covered calls and buying out of the money put options) as a relatively inexpensive way to risk protect your long-term focused equity portfolio exposure. Also, consider buying deep out of the money put options for risk protection.
Please note the comments at the bottom of this Trade Signals discussing a collared option strategy to hedge equity exposure using investor sentiment extremes is a guide to entry and exit. Go to www.CBOE.com to learn more. Hire an experienced advisor to help you. Never write naked option positions. We do not offer options strategies at CMG.
Several other links:
http://www.theoptionsguide.com/the-collar-strategy.aspx
https://www.trademonster.com/marketing/upcomingWebinarEvents.actionsrc=TRADA2&PC=T
RADA2&gclid=CKna3Puu6rwCFTRo7AodRiQAlw
Conclusion
The cyclical bull market trend for stocks remains in place; however, risk is elevated. A Median PE of 21 based on actual earnings puts the market approximately 20% above its 50 year fair value. Click here for PE and Profit Margin charts.
Sentiment may serve as a guide in determining when to put some form of risk protection in place. Think of it as inexpensive insurance. I will become much more concerned when the cyclical trend turns bearish.
A note on the cyclical trend in interest rates – rates have been moving lower and are nearing a point that may turn the cyclical trend for bonds from bear to bull. While there can be no guarantees in our business, I note that we have begun to see a shift towards bond ETFs in our tactical strategies.
With kind regards,
Steve
Stephen B. Blumenthal
Founder & CEO
CMG Capital Management Group, Inc.
Philadelphia – King of Prussia, PA
steve@cmgwealth.com
610-989-9090 Phone
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