Embrace Bullish Sentiment

• Posted by Greg Harmon
• on March 7th, 2013

How many time lately have you heard about sentiment showing that a top is in? Ah, like every day for weeks right? But what does that really mean? Sentiment results from surveying an audience among three simple responses: Bullish, Bearish and Neutral. The resulting responses give a Bullish percentage. Many look at this percentage charted relative to the S&P 500 and see a strong correlation. From the data below for the last 7 years it is easy to see that correlation. As the market rises the Bullish Sentiment rises and when it falls the Bullish Sentiment reading falls. Simple right. Here is where the problems come in. At the turning points many want to use the two data points, the S&P 500 and the Bullish Sentiment reading to predict a turn in the market. Everyone wants to be the hero and catch the top right, so why not? So they look at the level in Bullish Sentiment relative to past tops and start predicting a turn, what we have been seeing lately, or look for a divergence of one from the other to suggest that the second is about to turn, in a causal effect.

Used as one indicator in a mosaic of the marketplace this is fine. But as the lead indicator this becomes troublesome. Why? Two reasons. First, look closely at the Bullish Sentiment data. Look at that series closely. It is not very smooth. A statistician might suggest that to predict a turn in the S&P 500 based on a turn in this series would require a very substantial contra move in the Sentiment Indicator. Not so useful for a trader. Second, the perspective of a lofty Bullish Sentiment reading leading to a correction is more troublesome. Logic jumps in and says that in a S&P 500 move higher, and to new highs, shouldn’t the Bullish Sentiment be strong? Embrace the Bullish Sentiment. Most of the time the Sentiment direction accurately reflects the direction of the market. And even at historic high levels of near 60 that still leaves 40% that are not yet bullish. There is no reason it could not continue higher. There is value in using this data to round out a thesis on the market, no doubt about that, but beware those spouting Sentiment alone as a reason for a market turn. I am sure they will tell you they were right after it does turn. The question is how long did it take and how much of a move did they miss in the meantime.

Thanks to RyanDetrick at Schaeffer’s Investment Research, my neighbor to the south, for loaning me his chart.

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