On the Verge of the Best Month Ever

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When Standard & Poor's downgraded the credit rating of the United States at the beginning of August, investors turned extremely bearish. Over the course of the following weeks, the sentiment indicators went from moderate readings to some of most bearish readings in the past few years or longer.

The indicators I am talking about are the Investors Intelligence Report, the Rydex Nova/Ursa Ratio and the 21 day moving average of the CBOE Equity Put/Call Ratio. The Investors Intelligence Report measures the bullish percentage and the bearish percentage of newsletter writers like me. I find the best way to look at the results is as a ratio of the bullish percentage to the bearish percentage. This ratio dropped under 0.75 on October 12 and this was only the second time in the past two and a half years.

The Rydex family of funds has the Nova Fund which is a bullish fund and targets a return that is 150% of the return of the S&P 500. The Ursa fund is a bearish fund and targets a negative 100% correlation of the S&P 500. The ratio is simply the assets of the Nova fund divided by the assets on the Ursa fund. The higher the ratio, the more bullish investors are and the lower the ratio, investors are more pessimistic. The ratio was hovering in the 0.50 range in July and then plummeted to a reading of 0.15 in September.

The CBOE Equity Put/Call ratio and its 21-day moving average measure the number of bearish puts that are traded versus the number of bullish calls that are traded for any given day. This particular ratio only looks at individual equities and doesn't look at index options. The daily readings can vary wildly and thus the reason I like to use the 21-day moving average in order to smooth out the readings. The moving average was hovering in the 0.65 range in July and spiked all the way up to 0.81 in late August.

The point is that investor sentiment was extremely bearish after the downgrade. From a contrarian viewpoint, when investor sentiment reaches bearish extremes, it is usually a good sign that a rally is in the works. Why is that? Look at it this way, if everyone that wants to sell has already sold, there are more buyers than sellers left. In its simplest form, this is what makes a stock or a market go up- more buyers than sellers.

So after experiencing a big decline from the middle of July through the first 10 days of August, the market then traded in a range with the S&P stuck between 1,100 and 1,225. Even though we were caught in a range, the sentiment continued to move toward the bearish side.

At the beginning of October the market started to rally and many people thought we were just headed back up to the top of the range. And I have to admit, the thought occurred to me as well. But something different happened this time. Instead of seeing the sentiment shift abruptly to the bullish side like we saw at the end of June, the bearish sentiment wasn't dissipating. We also started to see better economic indicators around this time.

With the bearish sentiment, an improving economic outlook and companies reporting better than expected earnings, we had the making of a huge rally. How huge? As of the close on October 27, the S&P is up 13.54% for the month of October. At this point, October is in line to finish as the best performance month in the history of the S&P.

The market has entered an overbought status on the daily charts and we could see some profit taking over the next few days. As long as the selling isn't dramatic, the record performance should be safe. Even if the selling gets to be more than just profit taking, the performance for October has been impressive.

As long as the sentiment doesn't reverse too quickly, I see the rally continuing through the end of the year. I find tremendous value in watching the sentiment readings and I highly encourage you to add them to your repertoire of indicators. When you combine sentiment with fundamentals and technical indicators, you really get the total picture of what is happening in the market.

Until Tomorrow,

Rick Pendergraft
ETF Master Portfolio

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Investing , Stocks

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