How Deep Will the Market Pullback Be? Sentiment Holds the Key

There isn't much in the way of market moving news this morning. Our markets are lower, mostly taking their cue from overseas markets, which sold off again overnight. Shanghai fell -4.3%, with Hong Kong and Japan lower as well.

We got some solid earnings reports from Hewlett-Packard (HPQ) and Deere (DE), but they aren't having much effect on the market. That said, so far this pullback has again been rather mild. I'm not saying it's over, but given how overbought the market had become, I'm sure the bears were expecting a sharper correction.

From my perch, I think it all comes down to sentiment. The market had a fairly significant correction in July, with the S&P 500 retreating 9% from its highs to lows. But sentiment became highly bearish in short order, and the market rebounded and experienced a strong relief rally.

Could the same thing happen again? I doubt it will occur in the same fashion, but first we need to see how the sentiment indicators shape up. Many of them have moved too far in the complacent camp, and if that complacency persists, then any correction could last longer.

Here is a look at a few of the indicators I monitor:

• Investor's Intelligence survey: The spread between the bulls and bears hit +28% recently. This is the highest level since January 2008. Note that in July the spread moved back to +0%, so this indicator bears watching.
• AAII: This survey of individual investors bounced around more, but it recently hit +18%, its highest reading since May 2008. In July, it was deep in negative territory (more bears than bulls) at -27%.
• Rydex Nova/Ursa: This ratio measures assets flowing into the bullish Rydex market timing funds vs. the bearish funds. It recently fell to .56 after rising to .95 in July (a higher reading means more assets flowing into the bearish funds)
• 10-day put/call ratio: This is an options indicator of bearish put buying vs. bullish call buying. It currently stands at .81, which shows a little complacency. In July, it rose to .97, which showed far more skepticism.

As the market pulls back more, I will be watching to see if these indicators show rising levels of pessimism among investors. If that happens, then I would expect the pullback to be of the shallow variety again. Many pundits are warning about the fact that September and October are historically the worst months for the stock market. But if the market pulls back ahead of those months, and everyone is already hunkered down in their fallout shelters, the expected result might not come to fruition.

This is why I say sentiment holds the key. As we move closer to Q4, I expect some of the economic data to begin to improve at the margin. Also, as we move closer to 2010, when the economic recovery is expected to really show up, the stock market should begin to reflect stronger growth and work higher. This is why I would view any potential pullback in the market as another good opportunity to add to stocks that I think will be well higher a year from now.

Comments

[Larry House:]

Well, your first paragraph is old news, because now the markets are higher. I am sorry, but sentiment is a poor indicator of market action. Sentiment can turn on a dime. I have read and reread Graham & Dodd, and they don't mention sentiment. Sentiment is a house of cards. Words like "should," "could," and "might" give one cover, but they also show a lack of predictive ability--which is the main fact we now deal with; we just don't know and can't see what is coming.

Aug 19 01:43 PM

[Mad Hedge F...:]

hgk. There has been a lot of chatter in the blogosphere lately about the eerie and frightening similarities between our current global stock markets and those of 1937. Look at the great chart below, which I obtained from the ace quants at charlesnenner.com/. After a ferocious dead cat bounce and a tortuous period of sideways consolidation, we break down to a final Armageddon sell off. Top technical analyst, Louise Yamada, has also been highlighting this risk, and many big hedge funds are positioned accordingly. I believe that markets will always do what they have to do to screw the most people, and this would be it in spades. Imagine trying to trade the tedious 500 point range for six months, only to see the indexes drop by half and volatility double. You can kiss another generation of traders goodbye. Whatever you do, don’t short volatility here in the mid twenties in mid August.

Aug 19 03:14 PM

[dj10:]

Strong positive sentiment is never a contrarian indicator when bullish investors continue to put money to work.

The July drop in sentiment was likely augmented by the post traumaticstress so many are suffering after the market meltdowns of the last year.

Aug 19 04:42 PM

[greenshoots...:]

What pullback? I am just so sick of reading articles like this based on how the market USED to act. It doesn't take a genius to see that today's market is no longer using fundamentals, technicals or sentiment. What, with volume 1/2 of last years, and 70% of volume program, algorithm or hyper trading, what the hell does it mattter whether JoeSchmo is bullish or bearish, buying calls and puts.

It is simple. The market goes simply where the programs or large coordinated orders want it to go. 6 weeks now of this, with no pullback.

So stop writing these articles. I also got a Finance/Econ major, but I also know everything I have learned for the past 10 years in this industry no longer matters.

Aug 19 10:35 PM

[j-dub:]

Correct
If REALITY held the key, there wouldn't be a need for a pullback right now, because we'd be 20% off the bottom.

You gotta love the people who pretend it's all business as usual, instead of a whole new world.
That's pretty much why Macke went nuts-he was tired of the nonsense.


On Aug 19 10:35 PM greenshoots4everyone wrote:

> What pullback? I am just so sick of reading articles like this based
> on how the market USED to act. It doesn't take a genius to see that
> today's market is no longer using fundamentals, technicals or sentiment.
> What, with volume 1/2 of last years, and 70% of volume program, algorithm
> or hyper trading, what the hell does it mattter whether JoeSchmo
> is bullish or bearish, buying calls and puts.
>
> It is simple. The market goes simply where the programs or large
> coordinated orders want it to go. 6 weeks now of this, with no pullback.
>
>
> So stop writing these articles. I also got a Finance/Econ major,
> but I also know everything I have learned for the past 10 years in
> this industry no longer matters.

Aug 19 10:45 PM

[Denis Gould:]

The right call is to be bearish. That's why sentiment jumps on to the bear tack at the slightest provocation.But that short circuits any pullback. Only when we have all given up on the bear story can it happen. Thanks to behavioural finance markets are like looking into a pair of facing mirrors with reflections disappearing into infinity.

Aug 19 11:42 PM

[David Van K...:]

As stated above, what pullback? Are you counting two down days (last Friday and Monday) as a "pullback"? Or a "correction"?

I too think this is a sentiment-driven market, although one could argue that all markets, at all times, are sentiment-driven. I think the markets are trading on "net news flow," mostly about the economy, and that if the net news flow is predominantly positive, the market will tend to continue up. "Positive" includes any news that the economy is getting better, including "less bad" news (such as, new claims for unemployment are dropping, even though the total number of unemployed is rising, albeit at a slower rate).

No way do I believe that anything more than a minor noise-like pullback is inevitable. I also don't believe that it won't happen. Markets are markets, they surprise you. Keep your eye on your investments and hedges or sell-stops in place.

Aug 20 03:51 PM

[perceptions...:]

Let me say this, if the market goes down 50%, then goes up 50%, are you happy?

If that became a trend and happened 4 more times, over say the next 3 years or so, you know what is left of your $1,000,000 investment?

Answer = $237,304

So, up 50% & 50 % = Bad for your Wealth!!!

Aug 21 03:33 AM