But is there enough fear to form a bottom?

Investor sentiment is an important tool in market-timing, often indicating an approaching reversal in the market’s direction. It is also known as a ‘contrary indicator.’ That is, investors are usually bullish and full of confidence by the time a bull market or major rally has gone on long enough to reach a top. In the opposite direction, investors are usually at an extreme of bearishness and fear by the time a serious correction has reached a bottom.

Sentiment is the clearest indication of why most investors fail to keep the gains they make in bull markets. It has them buying more heavily at market tops and selling in despair near market bottoms. 

That is opposite to the strategy of most successful investors, including Wall Street institutions. Their goal is to sell into the market strength seen at market tops, usually exiting somewhat early, and then to re-accumulate positions at lower prices near the subsequent correction bottom. 

Ironically, among the numerous technical tools they use as to when to buy or sell are the sentiment readings of public investors, using them as a ‘contrary indicator.’ At the present time, most methods used to measure sentiment show it to be at an extreme of fear and pessimism usually seen at significant market lows. 

One of the oldest sentiment measuring tools is that of Investors Intelligence. It has been measuring the sentiment of investment newsletter editors since 1963. (As with most groups of market participants, newsletter editors also tend to be at an extreme of bullishness near market tops, and at extremes of bearishness near correction bottoms). 

In its October 22 review, Investors Intelligence reported that 54.4% of newsletters were in the bearish camp, the most since December, 1994 (when the 1990s bull market was about to accelerate to the upside in a big way). And only 22.2% were bullish, the lowest level of bulls since 1988. 

Another method of measuring sentiment, the VIX Index, also known as the Fear Index, has been getting a lot of attention among market technicians in recent weeks. Based on the implied volatility in the trading of S&P 500 futures on the Chicago Board Options Exchange, it measures the sentiment of options traders. The index rises as fear and bearishness rise, as always happens in market declines. 

Between 1998 and 2002, it reached maximum readings (of fear) between 45 and 50, at which time the market was very near important lows. Those readings occurred at the important low after the mini-crash in October 1998, and at the lows during the 2000-2002 bear market from which significant bear market rallies were launched. And it reached a reading of 45 in August of 2002, just prior to the final low of that three-year bear market. 

Over the last few years, VIX maxed out at levels of fear around 30, which was enough fear to see intermediate-term market rallies take place, such as off the March and July lows this year. But in recent weeks, as the market plunge accelerated in September and October, VIX began to surge up, reaching record levels of 70 and 80, far higher than the level of bearishness and fear seen at long-term bear market lows in the past.    

Meanwhile, the weekly poll of its members by the American Association of Individual Investors is considered to have reached extreme bearish readings, usually seen at significant market lows, when 55% of those polled are bearish, and fewer than 25% are bullish. The AAII poll reached an almost record level of 60.8% bearish on October 9 (although 31.4% remained bullish). And so far anyway, the market’s intraday low the next day, October 10, when the Dow fell intraday to 7,882, has been the low for the year. 

However, the extreme bearish reading of 60.8% on the AAII poll lasted only one week. The most recent poll shows that with the minor rally off that low, already only 33% of individual investors are bearish and 44.8% are now bullish. On a contrarian basis that quick loss of fear is disturbing.

Yet overall, the bearish investor sentiment is one area that provides encouragement for a bullish outlook, as does the arrival of the market’s favorable season. So we shall see. 

Sy Harding
Street Smart Report