Is The Small Trader 'Always' Wrong?

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Includes: SPY
by: Stock Traders Daily

Summary

Traditionally smaller investors sell at bottoms and buy at tops.

Theory tells us that they usually do the exact opposite of what they should.

But that theory is not absolutely true.

Whether you are a trader or an investor, you must constantly take precautions to avoid becoming a victim of myth and magic. Mythology is pervasive in the capital markets. It is always tempting to hide behind the untested as opposed to dealing with known technical factors about the markets. Traders enjoy technical terminology and frequently bandy about such terms as "the golden cross" or the "death cross." The commentators on financial television shows who once were deeply steeped in discussing fundamentals have suddenly become technical gurus and speak of chart patterns such as the head and shoulders, trendlines, breakouts, and the ever popular 200-day moving average. The vast majority of these popular indicators are more mythological than real. Simply stated this means that they have been untested and frequently a rigorous test of the reliability reveals mixed results in spite of what the new technical TV gurus would have us believe.

Other popular market myths abound. They frequently provide a false sense of comfort to traders. One of these "comforting" or perhaps "discomforting" statements is: "the small trader is always wrong." To me such a blanket statement is no more correct than the current controversial statement that "the stock market is rigged." We need to be careful what we tell ourselves lest we begin to believe it.

Let's try and evaluate the statement that "the small trader is always wrong" by looking at some objective data that may lend some credence to this belief or perhaps temper our confidence in this commonly held belief. Admittedly, this is not a rigorous test, but the data is available for testing.

Shown below is a chart of Standard & Poor's 500 futures plotted against the DAILY SENTIMENT INDEX (DSI) small trader sentiment index. The DSI has been collated daily since 1987 and provides a percentage of small trader bullish or bearish sentiment daily on active US futures markets. Support for the "small trader is always wrong" statement would be confirmed if there existed a high correlation between the index being extremely low at market bottoms and extremely high at market tops.

In other words, to put numbers on it, if 85% of the sample was bullish at market tops and 15% were bullish at market bottoms then this would support the statement that small traders were usually on the wrong side of the market when tops and bottoms occurred. When I refer to "the market" I am talking about the S&P 500 specifically, and that can be tracked using SPDR S&P 500 (SPY). In order for the "small trader is always wrong" statement to be true correlation would need to be 100%, which of course it is not.

DSI Index vs. S&P EMini 500 futures daily. High readings (i.e. 80% bullish or higher) correlate closely with market tops BUT NOT ALWAYS! I have marked (arrows) three instances in which small trader sentiment was very bullish but which DID NOT signal a market top. Small trade sentiment at two significant bottoms was correct but this is also not always the case. Simply stated, there are no absolutes or Holy Grails. My study of small trader sentiment back to 1987 suggests that the small trader is "not always wrong" but rather can serve as a setup or as a leading indicator of market turning points. If the small trader was "always" wrong they wouldn't play the game.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The information contained herein may have already been disseminated by Jake Bernstein through jakebernstein.com

Business relationship disclosure: By Jake Bernstein for Stock Traders Daily, and neither receive compensation from the publicly held companies mentioned in this article for writing this article.