Net Bullish Sentiment Drops Sharply

by Lance Roberts

The recent sell off in the markets during the month of June sent the "bulls-a-runnin" with investor sentiment dropping sharply as market prices fell and volatility increased.  However, the plunge in bullish psychology has come with only a mild decline in actual stock market prices as the Fed's liquidity interventions have kept a bid under the markets in recent weeks.  The two charts below are a combined index of weekly survey's of both individual and professional investors.

The first chart shows the "bullish/bearish ratio" which is simply the difference between the sum of the bulls divided by the sum of the bears.  When the index is above 2.0 the markets are generally very overbought and close to a correction. The recent peak at 2.5 was one of the highest levels on this index since 2005 so the subsequent correction was not much of a surprise.  A reading at 1.0, or below, is normally consistent with a greatly oversold market.  While the market has not reached historically oversold levels in terms of sentiment as of yet - it will likely not take too much more of a decline in asset prices, or a rise in volatility, to push investors further into the negative camp.

The second chart shows the data a little differently.  This is the "net bullish ratio" which is simply the number of bullish investors less the negative ones and compared to the S&P 500 index.  Currently, at 5.85, the net bullish ratio has declined to much lower levels of bullish sentiment after reaching a historically high level above 30.  As with the bull/bear ratio above it will likely not take much more of a decline in asset prices, or rise in volatility, to push the number of bullishly biased investors into negative territory.

As a contrarian investor these  indicators suggest that a short term bottom to this recent could be close by.  While bullish and bearish sentiment can give us some short term clues about investor extremes it is important to note that at turning points this data can be somewhat deceiving.  During positive trending markets low bull/bear ratios, and net bearish indications, are typically short term bottoms in a rising trend creating opportune levels to increase equity exposure.  However, in negatively trending markets, such low bullish biases are typically setups for a rally that should be sold into.  During the middle of market trends these actions are somewhat easy to determine:  Bullish trends - buy dips; Bearish trends - sell rallies.  However, it is much more difficult to determine such actions at market inflection points when the market is changing trends.

Currently, it is far too early to tell if the current market action is a topping process or simply just a "rest stop" on its way to further highs.  While the Fed's ongoing liquidity actions certainly suggest higher highs to come; slower profit growth, China/Euro-zone weakness, upcoming fiscal debates and a potential exit from QE could lead to a change in trend ahead.

Regardless, the increasingly negative sentiment of both professional and individual investors does indicate that the markets have begun to reduce some of the overly optimistic sentiment in the market.   Where the next rally takes the markets will tell us much about whether we have seen the peak of this market as of yet - or not.

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