Market Sentiment Remains a Red Flag

Jan. 7.11 | About: SPDR S&P (SPY)

The bullishness seems to be really spreading to every corner of the market. Several of the indicators of market sentiment have been rising to levels that generally correspond to market corrections. Some have in fact risen to multi-year highs, and have surpassed the levels recorded in 2007 during the all time high. While these measures can always get even more extreme, they are an important potential red flag.

Chart 1: Investor's Intelligence - Percent Bulls
Click to enlarge click to enlarge

Gauging sentiment is not an exact science, but I think this chart is pretty clear, of the advisers and newsletter writers polled, that the majority of them are bullish, recently hitting a high of almost 60%. This is the highest reading, going all the way back to the 2007 all time highs. Put into context, this reading is even more extreme than during 2007 because back then, the economy was humming along. Now, however, we have extreme optimism in the face of high employment, crushing deficits, a municipal bond market crashing, and an European debt crisis etc etc.

Chart 2: Investor's Intelligence - Percent Bears
Click to enlarge

While bulls have been surging, the ranks of those willing to stick their necks out and go against the crowd are slowly being depleted. Other than a few "perma-bears"; Rosenberg, Prechter, etc, it seems no one thinks 2011 will be anything other than spectacular for stocks. To quote Bob Farrell, "When all the experts and forecasts agree -- something else is going to happen."

Chart 3: Bull Bear Spread

Click to enlarge

While this may or may not be the start of something more significant than a correction, it would be wise to reduce exposure to stocks or at least hedge exposure. Previously, when the bull - bear spread has reached these levels, corrections have started, including the 2007 reversal off the all time highs.

Chart 4: AAII Percent Bulls
Click to enlarge

It seems that advisers and newsletter authors are not the only ones getting bullish. Individual investors, polled by the American Association of Individual Advisers, are also getting very bullish. In fact, individual investors are more bullish than they've been in years, surpassing the 2007 all time highs.

Options speculators seem to be jumping on board as well. I'm curious where the put call ratio will end up. There have now been 3 signals generated by the 5 day moving average, and it looks like there might be another signal generated by the 10 day moving average.

Chart 5: The Put Call Ratio - 5 day moving average
Click to enlarge

The current signal is very likely to be even more extreme than the two previous signals because 4 out of the last 5 days the put call ratio has closed below 1 standard deviation from the mean. Today, when the fifth day drops off, the 5 day moving average is going to move lower, much lower if the close today is again on the call side extreme.

Chart 6: VIX vs SPY
Click to enlarge

The VIX also is reflecting the rise in optimism; the VIX basically measures the cost of insuring a portfolio, once investors get complacent is ironically almost exactly when the market is about to decline. We can see from the chart above that the current level in the VIX has recently corresponded with reversals. I would also note that the last few days, the VIX has possibly started to turn upward.

I remember very clearly the bottom in March 2009; watching CNBC as stocks started to rise, every single guest said that the rise off the lows was a bear market rally that could be traded, but ultimately had to be sold, as the market was doomed to sink even lower. I'll never forget how intense the bearishness was among the herd. Today, we have the exact opposite picture. Watching CNBC as stocks hover at 2 year highs, every single guest is saying that 2011 will be great, and any correction must be bought for the market is only heading higher. All the major indicators of sentiment continue to hover near extremes while the measures of strength and breadth lag price, conditions that have accompanied almost every reversal.

Disclosure: I am short SPY.