Excessive Optimism By Options Traders is Negative Short-Term Signal for Stock Market. We use a variety of investor sentiment indicators as contrarian signals on the direction of the stock market. Largely because most investors, including so-called “expert” money managers and brokers, usually are wrong. One of the indicators we use is the Options Speculation Index. This indicator looks at put vs. call buying as a measure of trader sentiment about where the market is headed for the short term. As you can see from the chart below recent trading pushed the index to an excessively optimistic level of 1.3. This chart shows the traders opened up 30% more bullish contracts than bearish ones. And that is a signal for caution for the short term from a contrarian viewpoint. You can also see that this kind of level of excessive optimistic trading has not worked out well in terms of median returns and win rates.
Short-Term Sentiment Indicators on Stock Market Suggest Caution. We use investor sentiment as contrarian indicators on the direction of the stock market because historically the average investors is wrong. Intermediate sentiment indicators last week and again this week remained neutral. That means we can derive no guidance from them in terms of intermediate-term stock market direction. However, short-term indicators are telling us investors are trending toward the optimistic. And that’s a sign of caution for the short term. As you can see from the chart below the short-term CNN Fear/Greed Proxy is getting too high. Meanwhile the 10-day equity put/call ratio is now below .60 (see chart), which is a sign of too much short-term investor optimism.
Sentiment Indicators Not Saying Yay nor Nay on Stock Market Direction. We use investor sentiment as important indicators for guidance on the direction of the stock market. But there are times sentiment indicators can tell us little or nothing. For example, as you can see from the chart below, the SentimenTrader’s Smart Money/Dumb Money Confidence spread is stuck in the neutral range. So, what we do? Although sentiment is a valuable tool, it is among a number of indicators we use. For instance, we’re watching very closely the decline of share price of JP Morgan Chase (see Chart of the Week). It is the largest bank in the United States and sixth largest in the word in terms of assets. Future precipitous declines are a good indication of rough times ahead for both the market and the economy.
Unrelenting Negative News in Media is Bullish for Stock Market From Contrarian Viewpoint. We use investor sentiment as a contrarian indicator on the direction of the stock market because historically they are wrong. So, it is no wonder investors have been so skittish about the market in the face of unrelenting negative news in the media. As such, the media has enormous influence although the media historically is wrong. The chart below from the San Francisco Federal Reserve shows how wrong-headed the media historically has been when compared with the direction of the S&P 500. While the media remains unrelentingly negative, investor sentiment indicators are in so-called “mid-range.” In other words, they are not flashing sell signals as they were last fall but heading in that direction. That to us means there’s still room for some upward market momentum.
Investor Sentiment on Stock Market is Moving from Bullish Toward Cautious Signals. We use investor sentiment as contrarians indicators on the direction of the stock market. One of our favorite contrarian indicators is the Investor Intelligence poll of more than 100 newsletter editors. Historically they are no better at playing the stock market than the average investor. In other words, they usually get it wrong. During the past week bullish sentiment increased to 46.6% from 43.39%. Bearish sentiment slipped to 29.1% from 30.8% as more editors concluded the bear market was over. That is astounding in light of all the damage the pandemic is doing, including causing historic drops in the GDP. In fact, there is so much uncertainty about the future that 90% of the S&P 500 reporting companies have withdrawn forecasts on future financial results. Nevertheless, the spread between the bulls and bears increased to 17.5% from 12.5% (see chart).
Taken as a whole, the increased level of optimism is a signal that investors should be increasingly watchful about the true direction of the market as sentiment signals move from more bullish levels and the spreads widen toward levels that signal caution. It is important to remember that in late March the Investor Intelligence poll showed bears clearly outnumbering bulls with a negative spread of -11.6%. Negative spreads as they widen historically are strong bullish signals for the market from a contrarian viewpoint. And sure, enough the market since then moved up sharply, and with it bullish sentiment has been increasing while bearish sentiment is declining. And that means there’s far less certainty that the market is headed for another big upward move. The higher the spread, the more it is signaling market risk, particularly at +30% and higher. In fact, spreads over +40% and higher historically signal investors should take defensive measures.