Don’t Let Fear Or Greed Drive Your Investing

The buyers appeared to have dried up by last Friday’s open as after ten positive closes in the Dow Industrials the market became nervous ahead of President Trump’s DC speech. The stock market had traded lower several times last week but each day it has rebounded by the close. That was again the case on Friday as the Dow Industrials and S&P 500 closed higher.

The data from AAII on the individual investors revealed that  the bullish % rose 5.4% last week to 38.5%. The change was due to those moving out of the neutral camp . It had peaked on November 24th at 49.9%  and hit a low of 31.6% on January 26th.

bull

I have been following these numbers for decades and have always emphasized that they have to be fiiltered by the analysis of the market internals in order to identify important market bottoms.  I have found the data to be less reliable in identifying market tops.

Extremely low bullish readings can be quite accurate in identifying high levels of market fear as they identify periods where more investors are thinking about selling than buying stocks. For example, during the summer of 2010 the market was correcting and the bullish % dropped to a low of 20.7% on August 26th. The daily NYSE A/D line then moved to a new high on September 12th which indicated the correction was over.

There were also lows in 2011, 2013, 2014 and 2015 where bullish sentiment was quite low and the A/D lines indicated that it was a buying opportunity. Of course the most recent extreme low in bullish sentiment occurred in January and February of 2016.

wa2-24a

The insert on the chart shows that on January 14 the bullish % was at 17.9% which was the lowest reading since 2005. The bullish % dropped back to 19.24% on February 11th as the Spyder Trust (SPY) dropped slightly below the January low, line a.

In contrast that low was accompanied by a higher low in the S&P 500 A/D line (line c).  This bullish divergence was confirmed by a similar divergence in the McClellan oscillator and H/L data as I noted in my February 13th column.  Two weeks later the weekly A/D lines turned positive by moving above their WMAs.

wa2-24b

Many investors like to follow CNN’s Fear & Greed Index.  I have found this index to be much better at identifying high levels of Fear (market bottoms) than at market tops. This is due in part that when two of its components, stock price breadth and stock price strength, are very high my experience is that it indicates a positive trending market not a top.

High levels of these indicators are not necessarily bearish unless they start to diverge from prices and then turn lower. It should be noted that stock price breadth does not track the actual A/D data as it looks at the advancing and declining volume.

Put and Call option data is a contrary indicator as when too many are buying puts it is a sign that too many are bearish on stocks. Conversely during a prolonged period where the call buying is much higher than the put buying it can be a negative for the market and does indicate a high level of greed.  It is the change in their trends that generally indicates a market turn.

Given these caveats it can still be useful indicator for investors to follow as long as it is viewed with regard to the current analysis of the various A/D lines. I follow these A/D lines:  NYSE, S&P 500 A/D, Nasdaq 100 and Russell 2000 but do not find the Nasdaq Composite A/D line to be that valuable.

In January and February of 2016 the Index completed a double bottom below 20 before it turned sharply higher.  For investors the drops below the 20 level, that coincide with positive or bottoming action in the A/D lines, are often the best buying opportunities.

wa2-24c

During panic selloffs, like that which occurred in August of 2014, the Fear & Greed Index  can get very low as it dropped to 4 (point 1) which was down from a month earlier reading of 68.  In the middle of a strong rally one has to be careful about not missing good buying opportunities because of high levels in the index.

When I wrote last year’s June 18th column (“The Week Ahead: Is The Fear Trade Your Best Bet Now?”) the Index was well in Greed territory at 75 but the more important bullish % had dropped back to 25.4%. Te recent major breakout in the A/D lines had me urging investors not to be frightened out of the stock market because of the upcoming Brexit vote as the high Index level was a sign of strength.

Specifically I concluded that “There no signs on the horizon that we are on the verge of starting a new recession so even if there is a sharper correction than I am expecting I still expect stock prices to be higher by the end of the year. The previously recommended ETF buying zones for Viper ETF clients have been reached but were selected with a clear focus on the risk. Longer term investors should continue to favor positions in low cost, broadly based ETFs or mutual funds.”

The daily new highs in the major averages have caused an interruption in the large number of bearish articles from many of the perennial bears that dominated the commentary prior to the recent market surge. As I suggested last spring please research any author you are not familiar with as many of these bears have been negative for many years.

Over the near term the hibernating bears are likely a short-term negative as it will eventually lead to a market correction that will clear the air.  Such a pullback should create a buying opportunity.  Since the market leading PowerShares QQQ Trust (QQQ) had reached my upside targets from December the  Viper ETF traders took partial profits a week ago.

 

The continued improvement in both the inflation outlook and the economy in the Euro zone is another strong signal that these markets should be considered on a pullback. The Markit Eurozone Purchasing Managers Index has turned sharply higher and may be able to break through the downtrend that goes back to 1999.

The Economy

Last Tuesday’s flash PMI Manufacturing Index held firm in the latest report at 54.3 which was only down slightly from the prior reading at 55.1. The Existing Home Sales were very strong and well above expectations.

The Chicago Fed National Activity Index was a bit lower than expected as production was weak. In contrast the Kansas City Fed Manufacturing Index was better than the most forecasted. The always-volatile New Home Sales were lower than expected on Friday while Consumer Sentiment at 96.3 held firm.

This week we have Durable Goods, Pending Home Sales and the Dallas Fed Manufacturing Survey on Monday. This is followed by a full slate on Tuesday with GDP, the S&P Corelogic Case-Shillar HPI, Chicago PMI and Consumer Confidence.

This is followed Wednesday by the PMI Manufacturing Index, ISM Manufacturing Index and Construction Spending with the ISM Non-Manufacturing Index on Friday.

On Saturday morning I will be writing the Market Warp section of the Week Ahead and I will be updating the analysis of the weekly/daily A/D lines on the Spyder Trust (SPY), PowerShares QQQ Trust (QQQ) and iShares Russell 2000 (IWM as well as the financial ETFs.

The Market Wrap section will be released by noon  NY Time on Saturday. Check here on Forbes to get my full analysis and I will tell you what markets to watch in the week ahead.