The Right Stock At The Right Time®
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The Right Stock At The Right Time® |
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Market Timing – The Sentiment Index
The Market Edge "Sentiment Index" measures the market's bullish or bearish sentiment by following the status of eleven sentiment indicators. It is a measurement of the degree of optimism or pessimism prevalent in the market. Whenever the crowd becomes overly optimistic, a bearish condition, the readings from the Sentiment Index will drop into negative ground. Conversely, when fear is rampant, which is typically a bullish condition, the index will be in the +3 to +6 area.
Bull markets climb a wall of worry. They get their start after the market has been in a long down turn. Typically, economic conditions are horrible and the public could care less about the stock market. Conversely, bear markets usually start when things look great. The market has been in an extended up trend, economic conditions are strong and the public can't get enough of Wall Street. Determining when these conditions exist can be as simple as following the media. However, a more reliable approach is to track the status of several sentiment indicators which when viewed collectively are a good indication of when the market's sentiment is reaching either bullish or bearish extremes. Never hang your hat on a single indicator since they don’t always work alone. However, good results can be obtained when the majority of the indicators are pointed in the same direction. The following sentiment indicators, which are included in the Sentiment Index, have a proven history of accurately reflecting the market's mood and can be valuable tools in forecasting when a significant turn in the market is likely. Odd Lot Short Ratio (5 Day Avg.): The number of Odd Lot shares sold short divided by the total number of Odd Lot sales. The higher the ratio, the more bullish the indicator since this unsophisticated group of traders are seldom right when shorting stocks. Readings of 0 to 5 are regarded as bearish, 5.1 to 9.9 are neutral while 10 and higher are bullish. NYSE Short Interest & Ratio: The number of shares sold short on the NYSE divided by the average monthly trading volume: Values above 3.5 are bullish, 3.0 to 3.5 is Neutral and 0 to 3.0 is bearish. The NYSE short ratio is a measurement of sophisticated investors trading activities. Its importance lies in the fact that shares sold short must eventually be bought back providing potential buying power for the market. The indicator has lost some of its significance since the mid-1980's as a plethora of trading strategies have been developed that employed shorting shares as part of the approach which artificially inflates the ratio. However, it is still a good gauge of the prevailing sentiment in the market. NASDAQ Short Interest & Ratio: The number of shares sold short on the NASDAQ divided by the average monthly trading volume: Values above 3.5 are bullish, 3.0 to 3.5 is neutral and 0 to 3.0 is bearish. Like the NYSE Short Ratio, its importance lies in the fact that shares sold short must eventually be bought back providing potential buying power for the market. Public-Specialists Short Ratio: The number of NYSE shares sold short by the public divided by the number of shares sold short by the specialists. Readings over 60 are bullish, 36 to 59.99 is neutral while less than 36 is bearish. NYSE specialists are the most sophisticated traders on the street. Their function is to maintain an orderly market in the stocks in which they make a market. They accomplish this by buying stocks when there is an imbalance on their books and by shorting stocks when there is a shortage of supply. When the ratio moves over 60, it reflects a situation whereby the public is shorting more stock than the specialist which is a bullish condition. This can be the result of either a large public short condition, which must be covered, or a small specialist short position do to a lack of buying pressure in the market. Either scenario sets up a bullish condition for the market. Conversely, when the ratio declines below 36 it reflects a situation whereby the public is shorting less stock than is the specialist. This can be the result of either a small public short condition, which doesn't provide any fuel to the market, or a large specialist short position due to large buying pressure in the market. Either scenario sets up a bearish condition for the market. Put-Call Index Option Ratio: A five day moving average of the number of CBOE index put options divided by the number of index call options that have been purchased on a daily basis. Ratios greater than 1.70 are bullish, 1 to 1.69 is neutral and 0 to .99 is bearish. The Put-Call Option Ratio is an excellent measure of current bullish/bearish sentiment in the market. Whenever the crowd gets overly bullish or bearish, odds favor the market heading in the opposite direction. Note that this ratio is compiled from index puts and calls, not the equity options. Individual stocks are subject to numerous arbitrage and trading strategies that involve the use of options as a hedging mechanism and fail to provide accurate sentiment readings. Dividend Yield Spread: The relationship between the yield (dividend rate) for the stocks in the DJIA and the yield on the highest-grade corporate bonds: Ratios between 0 and 5 are bullish, 5.1 to 6 is neutral and 6 and above is bearish. A low spread is bullish since it indicates that on average, the rate of return from dividends compares favorably to those from high-grade corporate bonds. Large differences suggest that higher yields can be gotten from bonds, a negative for stocks. Mutual Fund Liquid Asset Ratio: The ratio of mutual fund cash to total assets. Ratios higher than 10 are bullish, 6 to 10 is neutral and 0 to 6 is bearish. With the explosion of mutual funds in the 1990's, the liquid asset ratio has become a significant sentiment indicator. When cash levels fall below 6, the public exposes the funds to potentially forced sales in the event of a rash of redemptions. Conversely, when funds have a surplus of cash, 10 and up, explosive buying potential exists. Bullish Investment Advisors: The percentage of newsletter writers who are bullish on the prospects for the market as measured by Investors Intelligence: 0 to 40 is bullish, 40.1 to 54.9 is neutral and 55 to 99 is bearish. The majority of newsletter publishers utilize trend following methods in determining their market calls and stock selections. As a result, this indicator typically trends either up or down in step with the market. As the market moves higher, a greater number of advisors hop aboard resulting in an increase in the percentage of bullish advisors. Assuming that individuals follow these advisors recommendations, the amount of available cash that they have earmarked for stocks declines leaving less fire power to fuel the advance. Bearish Investment Advisors: The percentage of newsletter writers who are bearish on the prospects for the market as measured by Investor's Intelligence. Readings over 50 are bullish, 21 to 49.9 is neutral and 0 to 20.9 are bearish. This indicator also trends either up or down in step with the market. As the market moves lower, a greater number of advisors throw in the towel resulting in an increase in the percentage of bearish advisors. Investor's cash reserves that are earmarked for stocks rises leaving a reservoir of potential firepower to fuel the next advance. Bearish + Corrections Total: The percentage of newsletter writers who are either bearish or forecasting a correction for the market as measured by Investors Intelligence. Readings between 0 and 29 are bearish, 20.1 to 69 is neutral and 69.1 to 100 is bullish. VIX (CBOE Volatility Index): VIX is a measurement of the level of implied volatility in index options. It is calculated by taking a weighted average of the implied volatility of eight OEX calls and puts with an average time to maturity of thirty-days. Low readings, between 0 to 20, signal complacency in the option pits and are bearish, 20.1 to 29 is neutral while readings over 29.1 are bullish. Each of the indicators are assigned a +1, 0 or -1 value based on its bullish, bearish or neutral connotation. The total of these values determines the status of the Sentiment Index. Totals of +3 and higher are bullish, 0 to +2 are neutral and less than 0 are bearish.
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The Market Edge 'Market Letter' combines three proprietary market-timing indexes into a computer model which attempts to forecast the intermediate term direction of the market as measured by the Dow Jones Industrial Average (DJIA). These indexes are the Cyclical Trend Index (CTI), the Sentiment Index and the Momentum Index. The collective readings from the three indexes form the Market Posture which can be either bullish, bearish or on rare occasions neutral.