Advisor Sentiment, Market Breadth, and Price Inflection Points are all excellent indicators that we use in our systematic investment models. When multiple indicators simultaneously provide the same signal, an investor has a sound, high-probability basis for making buy and sell decisions that result in excellent outcomes.
Today we will examine a few of the indicators employed in our quantitative strategies, utilizing independent data from several highly-respected firms in the investment world to present their case. Please be aware that ETFOptimize is not formally affiliated with InvestorsIntelligence.com, American Association of Individual Investors, StockCharts.com, or any of the other resource providers with data and charts authorized for use in this article.
Advisor Sentiment Reverses Course and Signals Opportunity
Sentiment has a long history as a useful investment indicator, and savvy investors regularly turn to resources such as Investors Intelligence Advisor's Sentiment Report to assess the equity-exposure positioning of investment advisors.
Investors Intelligence has published their Advisor's Sentiment Report for 56 years (since 1963), and its long lifespan is a testimony to the report's usefulness, with a consistent track record of predicting major market turn points. Each week, Investor's Intelligence (II) reviews a plethora of independent market advisory newsletters and websites to assesses those advisor's current stance on the market: Bullish, Bearish, or Correction/Neutral. However, this report does not provide the kind of predictive signals from professional investment advisors you might think it would...
Surprising to many, professional investment advisors have a track record that's not much better than investing novices when it comes to anticipating the future course of the market. Investors at virtually every experience level tend to become most enthusiastic about stocks after a long, robust run higher – and turn their most bearish, anticipating a continuation of declining prices – after shares have been falling for a while. Because of the natural heuristic to extrapolate current conditions and recent experiences far into the future, for the most part, advisor opinions should be ignored.
REVERSALS FROM EXTREMES ARE THE SECRET: When Investment Advisors opinions, collectively, reach significant extremes of bearishness or bullishness – and then reverse course – the Advisor Sentiment Report becomes extremely valuable as a coincident indicator of a strong market turnpoint. It's upon the reversal of sentiment from extreme levels that the advantage of this indicator is optimum, from the standpoint of both reliability and profitability.
Chart 1 below shows the Investor's Intelligence Advisor Sentiment Report for the last ten years, with the spread between Bullish and Bearish advisors indicated by the black line in the lower half of the chart. A green line shows the S&P 500 index in the upper half of the chart. We have color-coded the chart to indicate times when Investor's Intelligence says risk is elevated (readings between 40 and 50, yellow zone), and times when the firm classifies sentiment as dangerous (spreads greater than 50, red zone). We've also shaded the range where bearish sentiment is higher than bullish sentiment, creating negative spreads (in green).
A reversal from an extreme, wide spread (bulls significantly outnumber bears) is a Sell signal (denoted by the dotted-red arrow), and the occasions of a reversal from negative readings (more bearish advisors than bullish advisors, green zone) being historically excellent times to purchase shares (signals shown with dotted-green arrows). In the latter case, when readings go into the negative realm and then back to positive, that's a significant signal that a bull rally is close at hand.
Chart 1 below displays the Advisor Sentiment history for the last 10 years, with our appended Buying & Selling-opportunity signals displayed with dashed green and red arrows.
Chart 1: When Advisor Sentiment reverses from negative readings to positive readings, it's consistently a signal that a significant bull-market rally is imminent.
Reprinted by permission.
Most pertinent to this article, notice the green, upward-pointing arrows in Chart 1, which mark the relatively rare occasions when sentiment moved from extremely bearish readings with negative values (bears outnumber bulls), back to positive readings (bulls again outnumber bears). Each of these occasions was an excellent opportunity to purchase stocks for a highly profitable, multi-month bull market that lay just ahead.
Notice that the BEARISH signals (dotted-red arrows) – a reversal downward from either 'elevated' or 'dangerous' levels – are not nearly as accurate or definitive as the BULLISH signals (dotted-green arrow). For example, in 2014 and 2015, there were numerous times that Advisor's Sentiment pulled back sharply from readings in the ''Elevated Risk' (yellow)' zone, but none of these turned out to be actual harbingers of a market downturn until the final one in late-July, 2015.
While it's impossible to see in Chart 1, in the Investor's Intelligence Advisor Sentiment report dated January 2, the bull/bear spread returned to positive territory at +5.4%, up from -4.7% one week prior (January 2). Then last Wednesday (January 16), it jumped to 16.8% – the spread between 42.1% Bulls and 25.3% Bears.
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"Negative spreads only occur after a broad market decline and signal lowered risk to buy."
- John Gray, Editor, Investor's Intelligence Advisor Sentiment Report |
Chart 2 below shows a zoom of the last three years with more detail, separately identifying the Percentage of Bullish Advisors (red) and Percentage of Bearish Advisors (blue). Here you can see that Bearish Advisors outnumbered Bullish Advisors in late-December 2018, before reversing course in the first week of January back to a positive spread, denoted by the green arrow on the right side of the chart. Just as occurred nearly three years ago with the February 2016 reversal higher from inverted readings (green arrow on left side), there's an excellent chance that this reversal of sentiment will be a harbinger of a substantial rally.
Chart 2: Advisor Sentiment reversed from a negative reading in the Jan. 9 report, which has historically signaled the start of a bull rally. Reprinted by permission.
So we have an unequivocally bullish signal from the II Advisor Sentiment Report. Furthermore, we have been posting analysis since the market turmoil began last October showing that macroeconomic and stock fundamentals continue to remain durable, despite investor worries about a slowdown in 2019.
The bullish reversal of sentiment shown in Charts 1 & 2 above might typically be enough to trigger a monster bull rally, but we always rely on conformational data to ensure that any indicator signal is not one-off, chance, or erroneous. Therefore, it behooves us to examine a few more key indicators...
Why You Should Use a Signal Composite
Investors should remember that double-dips or double-bottoms are a common trait of stock prices during the bottoming process, occurring about half the time to mark a short-term or intermediate-cycle low. If you will refer back to Chart 1 above, you can see that there were classic double-bottom patterns during the lows of 2010, 2011, and 2016 in the S&P 500 following a BULLISH Advisor's Sentiment Signal.
Investors who bought on the first bullish signal during each of those years had to endure a nearly immediate and stressful loss of funds before the rally actually got underway. Losses that occur immediately after a significant purchase bring a feeling of failure, worry about poor judgment, and can cause investors to second-guess themselves and their approach, often resulting in self-defeating, emotionally driven decisions that are untethered to a systematic investment approach.
All too often, immediate paper losses from a double-dip retest of the lows results in investors making an emotional sale of their losing position to cut their losses. Of course, this locks in those immediate losses – losses which hurt even more when the market reverses course and heads higher in the rally that was originally expected.
There are multiple ways to deal with this challenge, such as scaling into a purchase, simply gutting it out if a double dip does occur, and other methods, but we find that the best approach is to utilize a composite of multiple signals, based on macroeconomics, stock fundamentals, technical indicators, and breadth indicators. Such a comprehensive composite makes market-turnpoint decisions a much higher-probability proposition, which can give you the confidence you need to stick with the position recommendations of your quantitative system.
Rather than show you the results of multiple indicators and go into some of our composite signals, will show you some of the critical indicators that are overriding the above, bullish Advisor's Sentiment indicator.
Avoiding the Pernicious Losses from Double Bottoms and Volatility
While multiple indicators show that reversals higher after a downturn can be a sound bullish signal, investors should remember that high levels of volatility are a common trait of stock prices during the process of finding a satisfactory level to bottom and reverse course. The increased volatility and testing of various price points that accompany a significant market turnpoint is a result of the battle between the Bulls and the Bears which plays out – frequently with great ferocity – in market prices, often with billions of dollars moving from weak to strong hands.
Previously, in Chart 1, we showed that there were double bottoms in 2010, 2011, and 2016, even after a longer-term Bullish signal had taken place. Investors who bought on that bullish signal had to endure a nearly immediate and stressful loss of funds before the real rally got underway. Losses that occur immediately after an all-in purchase can cause investors to second-guess themselves and their approach. Often, this results in an emotional sale within a week or two of buying, thereby locking in immediate losses.
One approach of avoiding immediate loss is to hold off on buying until you are confident there is minimal chance of a double-dip. However, the problem with that approach is you potentially miss out on the most aggressive part of the rally by sitting on the sidelines at the start. With double and triple-dip bottoms occurring about two-thirds of the time, how can we ever be sure that conditions are entirely safe for a purchase?
Another approach is to buy on the initial bullish signal, but just hold your nose if a subsequent double-dip retest of prior lows occurs. However, the fortitude of even the strongest-willed investor can wilt under the stress of the volatility inherent to a double- or triple-bottom pattern.
The best approach – one our firm takes with all our quantitative investment strategies – is to utilize a composite of multiple indicators based on macroeconomics, stock fundamentals, technicals, and breadth indicators. By using multi-faceted, composite systems for trade signals, investors can make trades with the confidence that they are going to turn out to be well-advised.
Trend and Breadth Remain Largely Bearish
In Chart 3 below, the top window shows the Trend of stocks. Prices remain below their 200-day Moving Average, and the 50-day Moving Average is below the 200-day Moving Average. The overall trend of stocks is DOWN.
For Breadth Indicators, window 2 shows the Percentage of Stocks above their 200-day Moving Average (bearish signal), window 3 displays the number of New Highs vs. New Lows (bearish signal), and 3) the Percentage of Advancing vs. Declining Stocks (bullish signal).
From this chart, we can see that the Long-term and Intermediate-term Trend remains down, while the weight-of-the-evidence from Breadth is Bearish.
Chart 3: The 50- and 200-day moving averages are bearish and trending lower, while two of three breadth indicators still show bearish readings.
Summary
Based upon more palatable valuations resulting from lower prices, combined with still-positive macroeconomic indicators and positive stock fundamentals that we have been discussing for the last few months – there has been a reduced risk to buy stocks.
Combined with the record-setting, bullish Advisor Sentiment reversal from negative levels (accompanied by additional indicators we will discuss next time), we believe that a monster bull-market rally could occur over the coming weeks and months. However, we need to see at least one of the two bearish breadth indicators switch to a bullish status.
To have confidence that a retest of prior lows is not immediately ahead for stocks, we would also like to see prices move back above their 200-day moving average and both short- and long-term trends heading higher.
In our next post, we will explore some additional indicators that are utilized in the ETFOptimize quantitative strategies, and what they are telling us about the prospects for stock prices in the intermediate future.
Using This Analysis with a Systematic Investment Model
Quantitative investment models avoid the most severe market drawdowns by occasionally moving into a risk-off asset, while systematically buying the most favorable ETF positions during bull markets – i.e., the solution offered by ETFOptimize.com. However, to take full advantage of these systematic models, subscribers must follow the recommendations of their model to the letter.
"Following the recommendations of your model to the letter" often means doing things that seem counterintuitive. However, always remember that whenever a recommendation from your model feels counterintuitive, there's a high likelihood that is one of those moments for a quantitative system that separates its superior, often-counterintuitive judgments from our own, all-to-human, emotional decision-making.
That's why we always strongly recommend that you use our analysis articles for informational purposes, but do not act on them. Instead, closely follow the recommendations of your model and buy/sell the ETF it does – at the same time it does. That is the approach investors must take to ensure they are following a systematic method – and not overriding that systematic approach with discretionary decisions that can devastate your savings.
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