Dhanvarsha: Is Sentiment too Bearish for Stocks to Decline?

Friday, September 10, 2010

Is Sentiment too Bearish for Stocks to Decline?

Dow... Higher start and lower ending ...indicating the real sentiment ...

In 1982, John Mellencamp's song 'It Hurts So Good' climbed the charts and became the number two hit on the Billboard Hot 100.

Over a quarter century later, the stock charts look so bad and some are wondering if this will result in an 'it hurts so good' time. In other words, is sentiment too bad for stocks to decline?

This question merits serious consideration, as investor sentiment is a reliable contrarian indicator. In fact, investors with the guts to buck the prevailing trend would have avoided much pain, heart ache and losses.

Gutsy Calls Rewarded

The 2000 tech (NYSEArca: VGT - News) crash was preceded by extreme optimism. The 2005 housing (NYSEArca: IYR - News) crash was preceded by extreme optimism. The 2007 financial (NYSEArca: XLF - News) crash was preceded by extreme optimism.

Using extreme optimism as a tell tale sign to sell or trim equity holdings would have been a smart move. Is the same true regarding pessimism? And more importantly, is the same true regarding the current pessimistic atmosphere?

We can use the March 2009 bottom as a reference, which most certainly coincided with extreme pessimism. Partially based on sentiment extremes, the ETF Profit Strategy Newsletter issued a Trend Change Alert on March 2, 2009 and predicted the biggest rally since the October 2007 all-time highs.

Even though the newsletter was mocked for its bullish outlook, the pessimism turned out to be the springboard for an 80%+ rally in the S&P (SNP: ^GSPC), Dow Jones (DJI: ^DJI) and Nasdaq (Nasdaq: ^IXIC). Could today's pessimism be compared to that of March 2009?

Comparing Today and the March 2009 Lows

Sentiment extremes are most reliable when they appear at the end of a trend. In March 2009 for example, pessimism reached an historic extreme after an 18-month decline that reduced the major stock indexes by some 55%.

By April 2010, after a 14-month rally, the extreme pessimism seen at the 2009 bottom had turned into extreme optimism. In fact, optimism had been so blatantly obvious that the ETF Profit Strategy Newsletter warned 'the message conveyed by the composite bullishness is unmistakably bearish. The pieces are in place for a major decline.'

Following the April highs, the market dropped as much as 20% and erased eight months worth of gains in a mere 22 trading days.

More Than just Sentiment

The chart below plots the S&P 500 against the percentage of bullish advisors and newsletter writers tracked by Investors Intelligence (II).

Even though the percentage of bullish advisors dropped to 22.2% on October 21, 2008, prices continued to decline for another five months. By the time the market bottomed for good, the percentage of bullish advisors stood at 26.4% (March 12, 2009). As of September 8, bullish advisors tracked by II make up 33.3%.

Two important lessons can be drawn from this: 1) Extreme investor pessimism does not necessarily signal a bottom 2) Sentiment gauges need to be viewed and analyzed in context with other market forecasting tools.

Sentiment - A Self-fulfilling Prophecy

There comes a point when sentiment becomes a self-fulfilling prophecy.

On May 14, the ETF Profit Strategy Newsletter predicted the following: 'Thus far, rising stocks have kept a lid on investors' disappointment with the government and corporate America. Once the market begins to fall, the combination of falling prices and negative news will bring more 'oddities' to the fore and create a negative feedback loop a la 2008. Bear markets are always the best auditors.'

This logical progression of selling leads to more selling. It is starting to take hold in the equity market - both domestically (NYSEArca: TMW - News) and abroad (NYSEArca: EFA - News). It can currently be observed in the real estate and retail sectors.

Years ago, it was believed - and many put their money where their mouth was - that real estate would always go up. This belief recently met with the realization that real estate is not always a sure thing.

After tons of government stimulus funding and the $8,000 home-buyers credit, real estate prices continue to fall. Why? Because potential investors feel that prices will drop further. Even homebuilders (NYSEArca: XHB -News) see no light at the end of the tunnel.

The same holds true for the retail sector (NYSEArca: XRT - News). The only way retailers can lure shoppers into their stores is by offering massive discounts. As discount shopping becomes an expected event, retailers will lose the ability to raise prices.

The Worst Still Ahead

Stock prices are based on valuations and perception. Valuations are tangible and can be calculated. Perception is intangible and irrational because it is caused by group pressure or the herding mentality.

In the very late 1990s, investors would pay $100 a share for a company that's never earned a dime. Stocks were clearly overvalued, but perception kept prices going up. Aside from a change in perception, there was no one memorable event that caused the 2000 tech bust.

In the 1930s, on the other hand, investors would bail on stocks - even the best blue chips - simply because everyone else was bailing. The need to raise cash combined with the perception that stocks would fall further resulted in falling prices.

It is interesting to note that the 50% stock market rally in 1929/1930 rekindled the same kind of optimism seen this April. On April 16th of 1930, stocks topped before tumbling 80%. On April 26th of 2010, stocks peaked in a similar fashion. Throughout most of the Great Depression, stock prices sank along with investor optimism.

Valuations and Technical Indicators

As mentioned, valuations can be measured by using dividend yields, earnings, or the Dow measured in real currency - gold (NYSEArca: GLD - News). Each of these valuation gauges points towards lower prices, much lower.

The bearish picture is compounded by bleak looking technicals. The Dow Jones is on the verge of confirming two head-and shoulders topping patterns, one going back as far as 15 years. There was also a confirmed Hindenburg Omen, which last occurred in June 2007. Also evident, is a rare technical topping pattern which suggests a steep decline towards lower prices.

Winston Churchill said: 'A pessimist sees the difficulty in every opportunity; an optimist sees the opportunity in every difficulty.'

Source..http://finance.yahoo.com/news/Is-Sentiment-too-Bearish-for-etfguide-955611931.html?x=0&.v=1