Introduction

The markets were down and then up. By the end of the week, investors seemed to breath a sigh of relief as the dip was bought and the markets ended on a positive note. Crisis was averted. Or was it just put off for another day?

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Last week, the price cycle had rolled over as the “dumb money” indicator (see figure 2) had gone from extremely bullish sentiment to neutral sentiment. My instructions to you were: “you need to be selling strength or the “dead cat” bounce that is likely to happen as prices are short term oversold.” The bounce did come, and we anticipated it well. (See the $VIX Report and this technical tidbit on “why” the market bounced.) With the end of the week prices on the SP500 closing above their open, this has produced a SELL signal in our equity model.

While the majority of investors are breathing that collective sigh of relief after last week’s roller coaster, I don’t see it that way. As the price cycle has peaked and rolled over, the next buying opportunity should come when investors turn extremely bearish in their outlook. By convention, the price cycle “dictates” that every sell signal should be followed by a buy signal and so forth. (There are variants, but we will discuss those at another time.) The best way to get these investors to turn bearish on equities is to have lower prices. So to get to the next buy signal, we need to have lower prices.

Now I want to clarify an important point. Our equity trading model is on a sell signal, yet the technicals are constructive as prices on the SP500 remain above important support levels (i.e., the 40 week moving average). This is what I would call a NEUTRAL market environment. Backtesting of such scenarios –i.e., equity trading model on a sell signal with prices on the SP500 above their 40 week moving average — produced some winners and some losers. If you were so smart over the past 23 years to only invest in the markets when such conditions existed, you would have not made any money, but you would have had a nice roller coaster ride. In essence, these trades would have produced an equity curve that moved like a sin wave across a graph. There is just no edge under these market conditions. However and it should be noted, that the last 2 years generally has produced some winning trades under such NEUTRAL market conditions. With QE and the excessive Federal Reserve jawboning to support the markets on even the slightest dip, the markets have been unable to really sell off and the price cycle has in-frequently reset after a sell signal. For example, the equity trading model generates 2.5 buy signals per year; 2013 only saw 1 such signal. This is another way of saying that it has been better to be a buy and hold investor over the past year as opposed to a trader. Or why sell when the Federal Reserve has your back?

The NEUTRAL market environment really serves two purposes. One, it defines a market environment where the SP500 has underperformed over the entirety of the data, and there is no predictable edge to the price action. Two, it gives investors an opportunity to reduce – -as opposed to being all in or all out like a light switch — their allocation to equities. With little predictive edge, why be in the markets full throttle? Look at investing this way. You are a card counting black jack player. You cannot predict the next winning hand or cards that come out of the shoe, but you can determine (and this is the sole purpose of card counting) when is the best time to bet heavy. A neutral market environment may or may not produce a winning trade, but it is not a time to be betting heavy. Got it?

The market narrative, whatever it may be, is likely reflective of the current neutral market environment. There will be both bullish and bearish talk. The investing mindset remains such that investors belief in the Federal Reserve or other central banks has yet to be shattered. I think that moment is a long ways off, and will coincide with a technical failure in the markets. So what do I mean by this? The markets will sell off at some point in the future and investor sentiment will turn bearish. We will become buyers when everyone else is bearish. The markets will lift like they do 80% of the time under such dynamics, and there might even be an announcement by the Fed that supports the markets and investors beliefs that the Fed has their back. But for whatever reason, the bounce will fail and the markets will move (crash?) lower not only violating those important technical levels that brought in the buyers in the first place but also destroy the notion that the Fed has control. That’s how I see a top in the markets. For now, I view the current top as an intermediate term top. It is too early to determine if this is going to be “the top”.

In our 4 Asset Model Portfolio, we closed our equity positions on Friday. We recognize the current neutral market environment may yield higher prices, but we believe the edge is not there. We turned bullish 22 weeks ago when investors were extremely bearish on the stock market. This marked the bottom of the current price cycle and the lows of the current market move. We sold our position this week on strength as we believe the price cycle has peaked. It is our expectation that lower prices will be required to turn investors bearish. This will provide us with another buying opportunity which will most likely reset the price cycle once again. Wash, rinse, repeat. There you have it.

Lastly, several comments regarding all of our sentiment indicators. In aggregate, they are neutral, and this seems to reflect the current neutral market environment. The “dumb money” indicator (figure 2) is neutral but heading towards a bull signal. The “smart money” (figure 3) is modestly bullish but not in an extreme way. The Rydex asset data (not shown) continues to rollover and shows that money is leaving the markets. It should be noted that these investors have had a good track record over the past 4 years. The $VIX is rolling over suggesting lower prices. There is no consensus amongst the indicators.

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The Sentimeter

Figure 1 is our composite sentiment indicator. This is the data behind the “Sentimeter”. This is our most comprehensive equity market sentiment indicator, and it is constructed from 10 different variables that assess investor sentiment and behavior. It utilizes opinion data (i.e., Investors Intelligence) as well as asset data and money flows (i.e., Rydex and insider buying). The indicator goes back to 2004. (Editor’s note: Subscribers to the TacticalBeta Gold Service have this data available for download.) This composite sentiment indicator moved to its most extreme position 10 weeks ago, and prior extremes since the 2009 are noted with the pink vertical bars. The March, 2010, February, 2011, and February, 2012 signals were spot on — warning of a market top. The November, 2010 and December, 2012 signals were failures in the sense that prices continued significantly higher. The current reading is neutral.

Figure 1. The Sentimeter

Dumb Money/ Smart Money

The “Dumb Money” indicator (see figure 2) looks for extremes in the data from 4 different groups of investors who historically have been wrong on the market: 1) Investors Intelligence; 2) MarketVane; 3) American Association of Individual Investors; and 4) the put call ratio. The indicator shows that investors are NEUTRAL.

Figure 2. The “Dumb Money”

Figure 3 is a weekly chart of the SP500 with the InsiderScore “entire market” value in the lower panel. From the InsiderScore weekly report: “Market-wide sentiment is showing diverging trends along market cap lines. Sentiment within the S&P 500 is trending negative as selling volume picks up following earnings announcements. Conversely, an Industry Buy Inflection, our strongest macro quantitative signal, has generated within the Russell 2000. This latter development comes as volume lifts off a seasonal low point and is the result of contributions from the Consumer Discretionary and Industrial Goods sectors, where Industry Buy Inflections also generated, and the Banking industry, which has seen the most buyers of any group. The last Industry Buy Inflection in the Russell 2000 came in November 2012 on the same day that the index hit what is now a 19-month low.”

Figure 3. InsiderScore “Entire Market” value/ weekly