In a previous Seeking Alpha article,'Dumb Money' And Investor Sentiment, we presented a 'counter-trend' pattern in the AAII investor sentiment index that can serve as a warning of pending weakness in equities.
We pointed out that the AAII investor sentiment index, normally acts as a contrarian indicator where high bullish readings and low bearish readings, tend to occur as the market rallies toward a top. However, there have been several periods in the recent past when the opposite has occurred; low bullish sentiment and high bearish sentiment as the market rallies. This is what we have called the 'counter-trend' pattern and which has warned of pending market weakness.
The green ovals on the chart below, highlight the five counter-trends that have developed since 2007, and which served to mark local tops in the SPX. The red ovals mark the reverse counter-trend where bear sentiment spikes down and bull sentiment spikes up after a correction in the SPX (again, the opposite of what normally happens).
The blue ovals point out a recent counter-trend that resulted in only a very minor correction in the SPX. The blue question-marks indicate the possibility that a significant counter-trend pattern may be forming along with a local top in the SPX. We say "local top" because, as we point out later in the article, fundamental and technical reasons lead us to believe that the SPX has further to go before a major top forms.
The chart below, gives a close-up view of the counter-trend that is possibly developing. If the pattern completes, a local top followed by a correction is probable.
The Rydex Fund Asset allocation indicator is another way of measuring investor sentiment. We like this indicator because it is not a self-reporting survey, it objectively shows where funds are investing their money. The chart below shows the ratio of bear assets to bull assets, and highlights (red arrows) how low bear:bull ratios correspond to market tops. Presently, the ratio is at an extreme low (red oval with question-mark), which implies a limited upside to the market.
Fundamental and Technical
The VIX provides a measure of investors' expectations of future volatility in the market. The chart below, shows how upward spikes in the ratio of price-to-earnings of the S&P 500, to the VIX (PE:VIX), correspond with local tops in the SPX, 90% of the time. The ratio is looking "spiky" at the moment, which demonstrates pervasive investor complacency, relative to PE. This also, implies limited upside for the market.
Looking at price, however, the market has room to move higher. The chart below, shows that the long-term moving averages (8 and 12 month) for the SPX, the MACD, and RSI,are all in uptrends in the long-term.
The GAAP earnings, also seem to be starting a long-term uptrend which has corresponded to rallies in the SPX. In the past, when the RSI has moved above 30, and the MACD has crossed-over to the upside (green ovals on the chart), the S&P 500 has rallied. Long-term, it is starting to look like the market has further to rise.
In conclusion: Investor sentiment is pointing to an over-bought situation in the S&P 500, and the likely-hood of a short-term correction. The fundamentals (GAAP), and technicals (price action) are pointing to a further continuation of the uptrend in the long-term.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.