Sentiment indicators still point to higher prices ahead

3 mins. to read

Let’s take a look at some of the various sentiment indicators we follow. What’s interesting to us is that most of these indicators are still pointing to relative extremes of pessimism, even in the face of the decent rally we have seen in equities in recent weeks. That’s nearly always a good sign for contrarians such as us. Remember, no matter how bad the news seems, when expectations are extremely low it is much easier to surprise to the upside. That is exactly where we find ourselves at this point

Probably my favorite sentiment indicator right now is what’s happening in short interest. Since April, we’ve seen a huge spike in short interest. In fact, the number of shares sold short recently climbed above the peak seen last September. What is extremely encouraging here for the bulls is that short interest has just begun to roll over and tick lower, suggesting the shorts could now be covering. Increasing short interest can be a goo potential headwind for stocks, and that headwind now appears to be receding. The last time short interest was this high and rolled over, we had a 30% rally in the S&P 500 over the subsequent six months. To me, its another sign that siding with the bulls is probably a wise move


Another indicator that continues to bode well for the bulls is the 10-day, equity-only, buy-to-open put/call volume ratio on the International Securities Exchange (ISE), Chicago Board Options Exchange (CBOE), and NASDAQ OMX PHLX (PHLX). This ratio recently peaked at its highest level since March 2009, but has since rolled over. Think about that — we had just a 10% pullback in the SPX, yet there was similar put buying to what we saw at a major generational panic bottom. This is simply amazing, and also sums up the overall level of fear that is out there. This ratio is still firmly pointing lower, and as you can see, a lower ratio has historically been rather bullish for equities.


It’s worth touching on mutual fund flows in the US aswell. Looking at domestic equity mutual funds, we can see record outflows over the past 12 months of around $175 billion. What’s really amazing is that, historically, the 12-month flows tends to move with the overall market. Yet, what has happened since the lows last summer is an increase in outflows, along with a steadily higher stock market. From a contrarian point of view, this could be extremely powerful, as it shows how much more potential there is for higher prices should any flows make their way back to equities.


And here’s a chart that also plots bond fund flows. This isn’t a huge surprise, but there has been about $200 billion in bond fund inflows during the past 12 months, trouncing the record outflows from domestic equity funds. This is now an extremely crowded trade. In fact, I think we are gearing up for a multi generational short opportunity in UK gilts & European bonds


Finally, here’s a real head-scratcher. We know most investors want nothing to do with this market, after getting burned by such incidents as the flash crash, the ill-fated Facebook IPO, and various scandals at banks (led by JPMorgan’s “London Whale” mess). Well, here’s more proof of just how low expectations are. The American Association of Individual Investors (AAII) sentiment poll came out last week with just 22% bulls, which is the lowest reading since August 2010. Plus, this marks the 11th straight week of more bears than bulls.

This is the sixth-longest such streak since 1987. Looking at the previous five times this has occurred, after 10 straight weeks of more bears the bulls, the SPX is up an average of more than 5% over the next 30 trading days — and it was higher all five times over the next 30-day period. Below is a chart of the 10-week moving average of the AAII bulls since 2002. As you can see, this is the lowest it’s been since March 2009, and it’s down near previous major buying points going back over the last 10 years. Makes you think this surprise summer rally might continue, doesn’t it?


In conclusion, the odds of higher prices are still very good right here. Friday’s weakness is a good opportunity in our opinion to position yourself long in Japanese, Spanish and Italian equities and begin to place your short bets on Gilts, Bunds and Treasuries.

Good luck next week!



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