MARKET SENTIMENT INDICATORS
by John A. Epeneter, PC

Technical analysis requires investors to identify a trend, position with that trend, and then considering exiting the position when the trend shows signs of reversing. A proper analogy is few people boarding a large boat. When we first get on a large boat and walk to one side, the boat remains balanced. As more people join us on our side of the large boat, it becomes crowded. Once too many people have arrived on our side, the boat, even it is supposed to large enough to withstand more weight, is no longer balanced and tips. Investing and trading activity acts in the same way. Eventually so many people rush into the market or the same stock that a market becomes overbought and is set to reverse. Just as the boat becomes overcrowded and tips, so too many market buyers rush into the stock market, filling it to capacity, and it rolls over.

We can also use sentiment indicators to gauge the market’s mood. When these indicators push too far in either direction, they indicate the "boat" is overcrowded, and could roll over. Thus we must be on the alert for a market turn.

There are many different sentiment indicators in the market.  Here are a few.

1. CBOE Volatility Index (VIX) – VIX is often referred to as the fear index. Based on option prices, VIX increases when investors buy put options to insure their portfolios against losses. A rising VIX indicates an increased need for insurance. By looking for spikes in the index, we can identify moments where fear has overwhelmed the market, giving us the opportunity to buy stocks at reduced levels. Look for a spike where the current price is 10 points above the 10-day moving average (MA). Such a quick move higher indicates mass fear. On the March 9, 2009 bear market low, the VIX reading was 49.68. On the October 10, 2007 bull market high, the VIX was 16.67.

 2. American Investors Intelligence Index (AAII) - This is a survey published in the Barron's weekly newspaper based on a sampling of private individual investors.  We do not have the index reading at March 9, 2009 and October 10, 2007 at this point.

 3. Put call ratio - The put call ratio is a popular tool specifically designed to help individual investors gauge the overall sentiment(mood) of the market. The ratio is calculated by dividing the number of traded put options by the number of trade call options. As this ratio increases, it can be interpreted to mean that investors are putting their money into put options rather than call options. An increase in traded put options signals that investors are either starting to speculate that the market will move lower, or starting to hedge their portfolios in case of a sell-off.

Why should you pay attention to this? An increasing ratio is a clear indication that investors are starting to move toward instruments that gain when prices decline rather than when they rise. Since the number of call options is found in the denominator of the ratio, a reduction in the number of traded calls will result in an increase in the value of the ratio. This is significant because the market is indicating that it is starting to dampen its bullish outlook.

The put-call ratio is primarily used by traders as a contrarian indicator when the values reach relatively extreme levels. This means that many traders will consider a large ratio a sign of a buying opportunity because they believe that the market holds an unjustly bearish outlook and that it will soon adjust, when those with short positions start looking for places to cover.There is no magic number that indicates that the market has created a bottom or a top, but generally traders will anticipate this by looking for spikes in the ratio or for when the ratio reaches levels that are outside of the normal trading range.

The March 9, 2009 bear market put/call ratio was .73, and four days later it went down to .71. The October 10, 2007 bull market high put/call ratio was .90. On October 19, 2007 the ratio rose to 1.16.

4. NYSE Bullish Percentage – This measures the percentage of stocks on the New York Stock Exchange (NYSE) that are in bullish technical patterns based on point and figure graphs. In a normal market we would expect this metric to range between 40 and 60%, as some strong stocks are offset by weaker ones. When the number travels too far to either extreme, it indicates markets are either overbought (greater than 80%) or oversold (less than 20%).

The March 9, 2009 bear market ratio was 12.1. The October 10, 2007 bull market high ratio was 65.3.

5. NYSE 200-day moving average – This is a measure of the percentage of NYSE stocks trading above their 200-day moving average (MA). The longer the MA the more weight it should be given. When we see the percentage of stocks above their 200-day MA rising or falling, it indicates the broad market is also heading in that direction. Sentiment indicators provide insight into the underlying strength of market movements. Look for extreme readings as an indication that prices are set to reverse.

The March 9, 2009 bear market MA was 3.8%. The October 10, 2007 bull market high ratio was 59.0.

6. S&P 500 Bullish Percentage - The BPSPX or S&P 500 Bullish Percent Index measures the breadth of the Standard & Poor's 500. Investors use the BPSPX to identify high and low levels of the S&P 500 index. Many technical analysts use the BPXPS to identify changes in the trend of the S&P 500. A reading above 70% is considered overbought with 80 considered an extremely overbought situation. When the BPSPX falls through the 70 level a sell signal is given. Oversold signals are given when the BPSPX gives a reading below 30%, while 20% is considered a better oversold indication. The BPXPX Index gives buy signals when it turns up through the 30% threshold, reversing its downtrend.