Investor complacency suggests a pullback soon

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Today we’ll look at some big picture contrarian / sentiment indicators to get a reading of current market risk. We’ll start off with some quick reminders of how and why contrarian tools are valuable to investors.

 

Why contrarian investing?

Accuracy of projections

Part of thinking independently is to question the validity and bias of our information sources. For example, Sell Side (brokerage) research is biased with an agenda to keep you buying investments. If a brokerage house says “get out, there’s nothing to buy”–that’s not good for business. The media is prone to print whatever is hot & in the news.  They quote industry players who support that excitement or fear. Its all about click bait. Its not about prudent forward-looking analysis.

My favorite whipping-boy is the yearly brokers market targets. They’re consistently inaccurately predicting overly pessimistic or optimistic targets. Here is the 2024 year-end SPX target list from all of the big US Sell-side analysts, published just a few weeks ago….

Here’s a chart from Bespoke on how accurate the Sell Side analysts are when predicting Fed rate moves. The black line is what actually happened, vs the blue lines/ consensus rate projections:

Hidden agendas and bias

Why are the Sell side analysts so inaccurate? Well, one thought is that they may be being “played” by the Fed. The US Federal Reserve is pretty much known (albeit never admitting) to use the big brokerages to whisper hints of potential decisions, ultimately pushing markets. Whether they follow through on those whispers is another question.

Canada’s media is is more obvious in their bias. Recently one brave media commentator finally commented on the media’s political bias favoring the Liberal government policies. This includes economic & other policies that can affect investors. Remember, here’s more than $600 million reasons for Canadian media’s bias!

Crowd behavior 

A time will come when men will go mad. And when they see someone who is not mad, they will attack him, saying “You are mad. You are not like us!” Anthony the Great

We just looked at accuracy, agenda and bias. Sentiment indicators quantitatively measure how the Fed, Sell side research analysts, and agenda driven media headlines influence crowds. Sentiment indicators help us spot those crowd driven buying-frenzies. Frenzies are spurred on by “TINA” (There is No Alternative to stocks), and more significantly “FOMO” (Fear of Missing Out). That’s the big one.

You can also quantitatively measure Capitulation and Fear phases of the crowd. Sentiment indicators also allow us to compare the moves of  “Smart Money” (institutions, commercial hedgers, large traders) against “Dumb Money” (retail & small traders, ETF & mutual fund flow). I wrote a book on this subject to aid you with using these tools. Here’s the link.

Today, we’ll look at a number of sentiment indicators to get a picture of current market risk. I’ll focus on a few key sentiment tools, including some that are NOT part of my Bear-o-meter collection.

 

VIX

The VIX looks at options premiums. When options traders suspect that volatility, particularly bearish volatility, is going to pick up, they assign bigger premiums to options. Its known as the “Fear gage”. When the VIX is “too low, it implies complacency. Money never sleeps, as is said. That complacency will be upset, eventually.

My rule of thumb is a level of about 12 indicates that investors are “too complacent” (bearish) and a level of 35 indicates they are “too fearful” (which is bullish!). The pattern is for complacency to set in, then a trigger motivates investors to sell, which in turn drives the VIX higher (option writers demanding more premium) as fear sets in. Fear reaches a crescendo, markets bottom, and the pattern repeats. Note that the VIX typically hovers in the complacency zone (12 or lower) for long periods of time before a true bear market ensues–note my circled areas on the chart.

Right now, the VIX hovers right around 12.8, touching 12 recently. The VIX hasn’t been in the sub-12 zone for an extensive period. This implies we are NOT set up for a bear market. But it is set up for a neartermed correction.

Historically, volatility rises as we come closer to the US Presidential election. That means a rising VIX, and choppy markets. The coming election on November 5th is going to be particularly filled with drama, given the polarization of politics these days.

 

Speaking of options….

“We are now seeing extremely bullish options activity in the collective Mag 6 names (META, AAPL, AMZN, GOOG/L, NVDA, MSFT), something we’ve witnessed 5 other times in the post-covid era (we’re looking back 3 years for this). It is interesting to have a look at forward returns when we’ve seen this type of activity; the 2-4 week forward window skews towards negative returns.” GS

The Put/call ratio gives us a picture of the ratio of puts vs options being traded on the markets. Normally we see a ratio that supports calls. Investors tend to buy less puts over the long run. This, given that markets are normally trending up. When the ratio gets too low (meaning too few puts are being traded), its a sign of complacency. My rule of thumb is 0.75 puts vs calls is a level of complacency, and a danger signal.

The put/call ratio currently sits near the danger zone at 0.84. But its not at the official bearish level.  Like the VIX, I look for clusters around 0.75 to indicate major leading bear market signals – like in 2021.

AAII

The American Association of Individual Investors is a  resource center for over 150,000 retail investors. They conduct an outlook survey, available on their website pitting bulls against bears amongst their members. For sentiment traders like me, the survey is a good measuring tool for “Dumb money” confidence.

Right now, dumb money hasn’t enough bears in the mix. That’s a bearish sign.

 

Fear & greed

CNN posts an indicator that acts a little like my Bear-o-meter. Its a compilation that incorporates a number of factors. I like it as a complementary tool to the Bear-o-meter.  While it uses some of the same tools I use, it is less focused on breadth than my compilation. Instead, it adds momentum studies to the mix – something that I use in my trend analysis. Note: Take my Online Trading Course, if you have not already, to understand how to use my complete trading system, including how to systematically employ both tend analysis and sentiment tools.

The CNN indicator has been stuck in the “Extreme Greed” category (above 75) for the past month.

Historically, the CNN Fear gage has provided some decent signals, like the peak and trough points in 2023.

 

Its not just retail money that’s dumb

Just like you guys are decidedly NOT “dumb money” insofar as retail/ individual investors go (by reading this blog, and using a systematic approach you are light years ahead of the crowd) – I like to think that Craig and I are a cut above the typical investment manager crowd. Yup, that’s right, just like the majority of retail investors are wrong at the worst times…so too are investment managers and advisors. The National Association of Active Investment Managers surveys my kin, and sure enough, these guys and gals are pretty much just as bad at market timing as the retail crowd. Just goes to show you…the 20/80 success rule falls into all categories.

Like the AAII retail investor score above – NAAIM members are in love with the market. Note how they, like the AAII investors, loved the market before the 2022 bear market too. I look for clusters to identify major market bear signals, but even brief spikes like this can indicate a neartermed correction is pending.

 

Conclusion

There’s enough evidence to suggest markets are complacent. If you subscribe to the ValueTrend Update newsletter, you’ll have received our latest edition in the past week. In that letter, we suggested the SPX would probably breach 5000, and then see a likely pullback in the latter half of February. The market just hit 5000 today, and I’d suspect it may get another bit of upside before a pullback. The indictors above seem to back that potential. For my money, I’m looking at holding a bit of cash, and holding only top Canadian stocks, along with value plays in the US markets.

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