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Bullish Sentiment Trend Suggests Growing Instability

ByEric De Groot
Published 10/30/2014, 07:42 AM
Updated 07/09/2023, 06:31 AM

The 'Panic of 2014', largely a hedge fund driven affair thus far, has yet to rattle individual investor. The sharp, nearly straight-line rally from the October 15th low has supported their relative calm. The latest sentiment survey from the American Associate of Individual Investors (AAII) confirms their calm as price rallies. Normalized sentiment has risen from -0.13 to 1.49 from October 16th to October 30. This impressive surge is confirmed by sharp decline in the VIX (Equity DI).

While opinion-driven investors view this sentiment shift an endorsement of the rally, they usually forget to mention that its horrible timing record make it a better contrarian indicator than leading indicator. Normalized sentiment readings, those exceeding +/- 1.96, depict extreme bullish and bearish sentiment, respectively. These setups, an indication of instability derived from misplaced sentiment of the majority, suggest growing instabilities behind the trend (price) and increase the probability of an unexpected reversal. Today's normalize sentiment reading of 1.49, a continuation of last week's uptick and the second highest reading since August 2014, reflects a market trending towards bullish instability within a cause building phase (chart).

Panic declines, even moderate ones, shift control of the trend from the weak to strong hands. This shift in control usually generates a bearish sentiment shift (from optimism to pessimism towards stocks). A market trend towards optimism despite the modest panic suggests an incomplete transfer of control. If this runs to completion, the strong hands will gain control as prices decline. In other words, the panic of 2014 may not be done.

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S&P 500

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