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To be sure, correctly analyzing investor sentiment and then acting accordingly in one's portfolio can be challenging over the long-term. Everybody knows to be wary of the crowd when everyone sees the same thing and/or everyone is expecting the same thing to happen in a given market. Yet at the same time, everyone can't be a contrarian, right?

The outlook for the current market is a perfect example of the sentiment dilemma. In short, most of the market sentiment indicators suggest that there is a great deal of optimism in the market at the present time. However, it is important to note that this may be one of the most hated market moves in history.

As the current Chairman of NAAIM (National Association of Active Investment Managers), I come in contact with a great many professional money managers on a regular basis. And the important point is that not a single one of them is pound-the-table bullish at this time. No, just about every manager I speak with is nervous to some degree right now.

But the market models designed to indicate degrees of optimism/pessimism tell a different story.

A Sentiment Indicator Worth Watching

For example, Ned Davis, proprietor of Ned Davis Research, has made a career (a very long and very successful career, I might add) out of analyzing investor sentiment. NDR has several investor sentiment models, one of which has been live for nearly 20 years. As such, when this indicator "talks" it is a good idea to "listen." And the bottom line is that Ned's indicator says sentiment is either at or very close to an extreme optimism reading.

This particular sentiment indicator looks at the data from Investors Intelligence, American Association of Individual Investors, CBOT Put/Call Ratios, Rydex Funds asset levels, MBH Commodity Advisors, as well as other indicators.

The trick to using the model successfully is to watch for an extreme level to be reached (in either direction) and then wait for the level of optimism/pessimism to reverse. This tells you that sentiment has become overdone and it is likely time for the market to go the other way. And history shows that heeding such an event has been quite profitable.

Below is a chart of the S&P 500, plotted weekly, with arrows placed at the peaks seen in NDR's sentiment indicator.

S&P 500 - Weekly

When reviewing the chart, it should be clear that extreme sentiment readings tend to lead to declines in the stock market. Sometimes the ensuing declines are modest. But then there have been times when the drops are quite meaningful.

For example, since the beginning of 2007, there have been 12 peaks in this indicator's optimism readings. If we measure the total S&P points between the peak in optimism and the ensuing extreme pessimism reading, we find that the S&P has lost a cumulative 1,830 points.

Another way to look at this is the S&P has lost an average of 166 points after each extreme reading in optimism.

Going back to 1995, there have been 41 extreme optimism readings. And in doing the math, we find that the S&P has lost a total of 10,500 points after the extreme readings. This means that on average, the S&P has lost an average of 256 points after the peaks in optimism have been reached.

What's more, over the last 19 years, the market has NEVER gained ground after an extreme optimistic reading has been reached until the next extreme pessimism reading. NEVER.

The Big Point

Sure, there are some big losses - 2008 for example - that clearly impact the mean loss for this indicator. But the key point is that peaks in optimism have simply NOT been good spots to buy.

What Is The Indicator Saying Now?

As of last week, this sentiment indicator is not an extreme level for the current cycle. However, the current reading is either higher than or very close to the peaks seen in May 2013, September 2012, March 2012, July 2011, April 2010, January 2010, June 2009 and May 2007.

To be clear, the indicator is NOT flashing a sell signal at this point. However, it is worth noting that the sentiment indicators suggest that optimism is quite high - and could easily reverse should the bears find a raison d'être.

Therefore, it is probably a good idea to recognize that risk is elevated at this time and that one should play the game accordingly. In other words, this is no time to be complacent.

Turning to This Morning...

The focus in the early going appears to have shifted from Iraq's geopolitical issues to the macroeconomic news of the day. The bottom line is there is good news and bad news this morning. First the good news. China's HSBC/Markit Flash PMI reading came in at 50.8, which was a seven-month high and more importantly, moved back above 50 and into expansion mode. Now for the bad news. The Flash PMIs from across the pond were all weaker than expected for both the manufacturing and services sectors. While the Eurozone's Flash PMIs remained above 50 (indicating expansion), the readings were below expectations and save Germany's Manufacturing PMI, below last month's readings. In addition, France's numbers were noticeably soft with the country's flash manufacturing PMI coming in at 47.8. The weak Eurozone numbers are weighing on the financial markets as U.S. stock futures, which had been higher overnight on the back of China's news, now point to a slightly lower open on Wall Street.

Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell...

Major Foreign Markets:
- Japan: +0.03%
- Hong Kong: +0.13%
- Shanghai: -1.68%
- London: -0.19%
- Germany: -0.21%
- France: -0.25%
- Italy: -1.01%
- Spain: -0.19%

Crude Oil Futures: -$0.10 to $106.73

Gold: -$3.30 at $11313.30

Dollar: higher against the yen, euro and pound.

10-Year Bond Yield: Currently trading at 2.599%

Stock Futures Ahead of Open in U.S. (relative to fair value):
- S&P 500: -1.22
- Dow Jones Industrial Average: -11
- Nasdaq Composite: -2.74

Thought For The Day...

To wish you were someone else is to waste the person you are - Sven Goran Eriksson

Positions in stocks mentioned: None.

The opinions and forecasts expressed herein are those of Mr. David Moenning and may not actually come to pass. Mr. Moenning's opinions and viewpoints regarding the future of the markets should not be construed as recommendations. The analysis and information in this report and on our website is for informational purposes only. No part of the material presented in this report or on our websites is intended as an investment recommendation or investment advice. Neither the information nor any opinion expressed nor any Portfolio constitutes a solicitation to purchase or sell securities or any investment program. The opinions and forecasts expressed are those of the editors of StateoftheMarkets.com and may not actually come to pass. The opinions and viewpoints regarding the future of the markets should not be construed as recommendations of any specific security nor specific investment advice. One should always consult an investment professional before making any investment.

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Source: Daily State Of The Markets: Is Sentiment Flashing A Warning To Investors?