Sunday, June 12, 2011

Contrarian at Extremes

You cannot just buy because sentiment is bearish and expect to make money.  It works more often than not but when it doesn't work, it can be painful.  You would have likely bought at SPX 1310-1320 in May.   That is a 40 - 50 point hit.  Sentiment has been bearish for over 3 weeks now.  This is based on the AAII sentiment survey and various put call ratios.  Yet we keep going lower. 

In the stock market, it is natural for the sentiment to get more bearish as the market goes lower.  It would be strange otherwise and actually have more meaning if it was not the case.  Only at extremes does being contrarian help in making high probability trades.  We are getting closer to those extremes right now.  So it becomes more dangerous to short the market.  Ironically, the best short daytrading set ups (like Friday) occur in this type of environment of worry.  Along with the worst longer term short set ups. 

4 comments:

Anonymous said...

I would agree-but riddle me this Batman-
Who would be buying here and why?

Why wouldn't they have bought on Friday? Are they buying for a quick up move? Then selling again.

All the same fears are still out there. The debt ceiling. Unemployment, real estate market, Europe defaulting. The only positive is oil seems to be trending lower. If that spikes up again forget about it!

Until some issues are resolved,why buy now?

Anonymous said...

when the intermediary trend is persistent, the last section of the move is typically exagerrated

Anonymous said...

It's normal that sentiment goes along with the market, it's an indication when it is more volatile than the market.

Nearly every measure of sentiment is significantly more depressed than it was at the march lows even though we are still above those (although not by much anymore).

Another rare case is that both OEX and total equity P/C ratios are trading much more put options than average. So both the smart and the dumb money is making bearish hedges and nobody is buying.

Yet apparantly nobody is selling aggressively either. I'd be very surprised if we will have seen much more downside from here in a month from now.

This in contrast with the later part of 2007 and 2008 (as well as 2001-2003 and any other bear market) where sentiment reached new highs before price when there were sporadic bounces. Sentiment on its own doesn't mean much, but sentiment relative to price action does.

Market Owl said...

Yes, you nailed it about the current environment. The sentiment is more bearish than the price action, even though we're down 6 weeks straight. But we're only down about 7% from the top.

But it will not be another V bounce because you really only get those after panicky trading. And we have had none of that this time down.