Sentiment Analysis and Stock Market Timing

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The above chart shows a very clear pattern. Each time the S&P 500 pulls back below the 55-day moving average, a sharp rally lasting on average two weeks follows. These moves depict increased participation from buyers which means the index can closed up day after day without any pull back. In fact if you check each bounce above the 55-day moving average you will notice very few down days. The latest bounce started deep below the 55-day moving average, so far the S&P has closed up five times in seven trading days.

This behaviour is caused by the current state of sentiment. Since March 2013 the stock market has been in a first degree extreme in bullish sentiment. This condition occurs after a long and sharp advance. The current bull market is five-year old, during this period the S&P is up 147%. A first degree extreme in bullish sentiment is characterised by a multitude of sentiment indicators reaching multi-year extremes in bullish sentiment.

Basically, when there are too many bulls, bullish sentiment indicators like the percentage of bullish advisors will reach an extreme level. This explains why the rallies from oversold levels below the 55-day moving average are powerful, there are simply too many buyers and not enough sellers. The irony is that when the stock market is in this phase the rally is unlikely to continue. There are many past examples of major top that occurred when the stock market was in a first degree extreme in bullish sentiment. This is why analysts who study sentiment are calling for a major correction.

I believe that those who are calling for a major correction, including me, will be proven right, but the question is when will the trend turn down? This state of sentiment can remain in place for a long period of time, the current state is nearly one year old and the stock market has yet to turn down. This extreme in bullish sentiment will only change when the stock market trend turns down and the decline becomes large in terms of magnitude and duration. For example the 2009 low coincided with a first degree extreme in bearish sentiment. As we can see that was a signal to go long.

What I have observed is that during a first degree extreme in sentiment we have waves of second degree sentiment. Sentiment will alternate between bullish and bearish as shown on the following chart:

 

Each time the two colored lines go down at the same time second degree sentiment is bearish and the stock market goes down. When they both rise, second degree sentiment is bullish and in this case odds favour a stock market rally. I use second degree sentiment to trade the FTSE 100. I assume that the long term trend will be down due to the first degree extreme in bullish sentiment, but in the short term second degree sentiment helps me find the near term trend and right now second degree sentiment is bearish.

Thierry Laduguie is FTSE 100 Trading Strategist at www.e-yield.com

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