Sentiment indicators point to rally in the days ahead

Whilst looking for inspiration for this mornings blog this weekend after what was largely a drubbing in the markets last week, I came across the following sentiment indicator details which although relating to the US has obvious spill over to the UK.

1.The most recent American Association of Individual Investors (AAII) poll is showing the most bearish reading since the August 2011 bottom, suggesting those retail players that are actively engaged are not feeling good about the market’s prospects. My own sense is that a lot of margined players were cut/flushed out last week in the UK too.

2. Equity option buyers, who grew optimistic right ahead of the election, are downright pessimistic, as the five-day put/call volume ratio is trading around extreme lows. This is my favourite indicator and for 6 days now the indicator has been popping over the key 1 level (ie 1 Put purchased for every 1 Call, typically it is around 3 calls for every 2 Puts) – as relayed on Friday, this is a strong signal that a bottom of sorts is close.

3. Total short interest on SPX components remains just below the levels of this time last year, which means the short-covering play is still intact. The caveat here is the shorts are feeling a lot less pain now than a few weeks ago, so the urge to cover is not as great now.

With valuations in the UK returning to very cheap levels, particularly in the mining sector (a rally is afoot this morning in some of our favourite stocks) and stocks very oversold, any more positive noises on the Fiscal Cliff and we could rally back to the 5800 level in the next several days in our opinion.

FTSE 10 day hourly chart

KEY LEVELS TO WATCH