Sentiment Not All It's Cracked Up to Be

11/08/2013 6:00 am EST

Focus: STRATEGIES

Technician Greg Harmon of Dragonfly Capital plays devil’s advocate and offers his take on what the latest sentiment indicators are saying about the parade of record-setting highs for the markets.

The latest sentiment data going around is gathering some buzz as some note that it shows that bearish sentiment is at six-year lows. This data is used by many as a contrarian indicator and often to very profitable outcomes. I have used it for some very profitable trades as well.

Here are the latest data from Investors Intelligence (II):

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And retail data from the American Association of Individual Investors (AAII):

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Both are pretty extreme. Well, both are near the limits they have seem before. As my friend Ryan Detrick points though, many other indicators are pointing to the market continuing higher. How can this be?

One possibility goes back to the very basics. When markets are rising, many are bullish, and when they are falling, many are bearish. Trading on sentiment signals takes that a step further and looks at extreme measures of sentiment as an indication of a top or bottom. The process we are taught as technicians is that at the extremes the popular view is often wrong and signals a turn. The problem with applying that thinking is that it matters what you are calling extreme. To be more specific, the sentiment rule should be read as: At market extremes, the sentiment for pushing the market further is often wrong. This also means that it is ok for bullish sentiment to be high and rising in a bull market. The key missing piece in this current situation is that the market is not at extremes. Look at the monthly chart of the S&P 500 below. It is just breaking out of a multi year range.

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You could have made an argument that it was at an extreme value when it was approaching the top of that range, but now, well beyond it we know that was wrong. So why is sentiment at the upper and lower bounds with the other market indicators signaling more upside coming? Perhaps, we are just in a strong bull market.

By Greg Harmon of Dragonfly Capital

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