Investor Survey Saaaaaaaays: Watch Out!

by Johnson Research Group | September 26, 2012 12:23 pm

One great way to get the pulse of market sentiment is through the weekly Investor’s Intelligence Sentiment Poll, which tracking the outlooks for more than 130 independent stock market newsletters. Every week, the poll publishes the percentage of bullish and bearish outlooks, along with the percentage of editors that are expecting a correction.

Over the years, this poll has become one of the more effective contrarian indicators available to investors, along with the CBOE Volatility Index (a.k.a. the VIX).

The concept of following investor polls as a contrarian indicator is fairly simple: Stock prices are driven higher when cash is available to move into stocks. So how do you track that? Well, by watching investor polls, of course.

It stands true that the most sideline cash is available when everyone is bearish, which is why market bottoms are drawn when investor polls show that everyone is bearish. Conversely, it stands true that the least amount of sideline cash is available when everyone is bullish. This is based on the idea that if everyone is bullish, then they’ve likely invested their cash into the market, meaning there is less available to move stock prices higher.

Put simply: The best time to sell stocks is when everyone else is bullish, and the best time to buy stocks is when everyone else is bearish.

Now, onto the latest Investor Intelligence poll data:

As of last week, the percentage of bulls hit 54.2% compared to the bearish percentage of 24.5%. The bullish reading is the highest since February this year, when the bulls topped out at 54.8%.

While monitoring the percentage of bulls is important, though, our experience has shown us that the ratio of bulls/bears is more effective in determining when the market is nearing a top.

Currently, the bull/bear ratio stands at 2.2, meaning there are more than double the bulls than bears. The last time that we saw a ratio this high was in March, just as the S&P 500 was getting ready to correct by almost 5%. The chart below identifies the period earlier this year when the bulls/bears encroached the 2.0 level:

What does this mean for the current market?

In addition to the relatively bullish readings of the Investor’s Intelligence data, the VIX is flashing a warning sign. Not so surprisingly, the VIX is trolling near its low readings around the 14 level — the same place it was trading in August when the market slowed, and the same place it was trading in March when the market rolled over.

How do we position for what appears to be a sentiment-driven pullback in stocks? First, three numbers to watch:

2 Simple Plays for a Weak S&P 500

ProShares UltraShort S&P500 (NYSE:SDS[2]): This ETF provides investors with a way to short the S&P 500 with some leverage. SDS shares theoretically should go up about 2% for every 1% decline in the SPX (though because of daily rebalancing, the performance can differ in the long run). We’re targeting a move back to $14.50, which is an 8% return. In addition, we would recommend a stop-loss price of $13, in case the market zigs when we’re expecting a zag.

iPath S&P 500 VIX ST Futures ETN (NYSE:VXX[3]): Trade volatility like a pro with this holding as it allows investors to “go long” volatility. VXX shares increase along with the VIX, meaning that a shift in the volatility trend will increase this hedge. We’re targeting a move back to $9.90, which would be a 13.5% profit from current prices. Like the SDS idea, we recommend a stop-loss price of about $8.45 to keep this hedge from running the wrong direction if the market finds its legs.

As of this writing, Chris Johnson did not hold a position in any of the aforementioned securities.

  1. IWM:
  2. SDS:
  3. VXX:

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