In this article, we update the two main sentiment indicators and detail two likely market outcomes.
The main sentiment indicators
Leading Liquidation Indicators are composed of other well-tested sentiment indicators. The theory behind these sentiment indicators is contrarian sentiment theory. MS extension is long term, while the ST-MSI is short-term. The methodology and concepts behind it are fully explained in this (previous article).
Since September 30 and October 7, when the two main sentiment indicators recorded their most extreme readings, the S&P 500 has risen 14% and 12.3%, respectively. These moments were highlighted in this (October article).
The MSI
As the 16-year chart below shows, the most recent MSI reading is minus 5.8, which is outside the extremely bearish green zone. The green zone begins when the MSI is more than 90% from its historical extremes.
As the chart shows, it has been in and around the green belt for most of last year. The current reading means it is 78.3% above its historical readings, which date back to 2007. Zero on the scale is 50-50. The extreme high is below 10% of its readings.
The black arrows indicate higher readings from the green bearish zone on this index over the past 16 years. Each was a great buying opportunity. Readers should seek out and read the two previous articles for a more complete explanation.
The table below the chart shows each of the nine sentiment indicators that make up the composite and their current position on the SK rating scale. The stock options report and the American Association of Individual Investors' sentiment survey are still recording long-term bearish readings. This is bullish, the theory suggests.
Leading gauge of sentiment towards the S&P 500 (Michael McDonald)
Sentiment Indicators Master Chart (Michael McDonald)
The ST-MSI
The Short-Term Leading Sentiment Indicator is composed of seven different sentiment indicators and is calculated daily. It is intended to signal short- and medium-term market movements. Since last Thursday, ST-MSI The reading was minus 4.7, which is still relatively bearish considering the size and duration of the current price increase. This indicates that the compound is 73.6% above its historical values measured over 15 years. The green zone is 909%. A neutral reading would be 50%.
The table below the chart shows the status of the seven indicators that make up the composite. The high volume of buying in ProShares bear funds is keeping this indicator near the green zone.
Both sentiment indicators suggest that this stock market has rallied against a "wall of doubt and worry." This "tension" is one of the classic signs of the beginning of a new bull market.
Leading Short-Term Sentiment Indicator Against the S&P 500 (Michael McDonald)
ST-MSI Indicators Table (Michael McDonald)
Probable results
What's most obvious when looking at the S&P 500 chart is how small this year-long decline appears against the backdrop of the previous rally. To us, the chart pattern looks like a high-level consolidation after a major advance, with everyone turning bearish.
We remain extremely bullish after sentiment readings over the summer matched the highest bearish readings measured in 50 years. For us, this requires a move in the S&P 500's low to the January 3, 2022, high of $4,742. That would be a $16% gain from here.
We don't believe this is a bear market rally. Bear market rallies are usually accompanied by a quick reversal in sentiment to the upside, setting the stage for another price drop. As you can see from both indicators, we don't have that right now. In fact, we have the opposite. With so many bears still around, there aren't enough sellers to drive prices lower, so prices are almost certain to rise, even with a moderate amount of buying.
If we're right and the S&P 500 returns to US$$ 4,700, the decision will be whether we'll move higher or lower again. In other words, this yearlong high-level consolidation may not be over. But that decision is a 15 percentage point decision and will be made for another day.
Economy
Note that we haven't mentioned the economics of the current situation. Contrary opinion theory never ends, because it almost always forces us to go against the economic exceptions of the majority. It recognizes that when many people have these expectations, history shows they are often wrong.
That said, we wrote the following on October 25 about the economic outlook.
We believe the data strongly supports the idea that the CPI peak is over and that inflation and interest rates will gradually return to lower levels next summer. If this is correct, I expect investor recognition to happen gradually over the next three months. But the Fed will also see this, and we should also see a sudden policy shift in response. That would be the trigger. We would be in a recession, rates would be about to fall, and stocks, which always start in a recession, would be 10% to 15% higher.
Unless there is a catastrophic situation like an unexpected nuclear event in the war in Ukraine, we still think it is correct.
This article was written by
Michael James McDonald is a stock market analyst, author, and former senior vice president of investments at what is now Morgan Stanley. He is a longtime proponent of contrarian sentiment theory and measuring investor sentiment to predict price direction. His first book, "A Strategic Guide to the Coming Roller Coaster Market," was published in June 2000, three months before the dot-com peak. The cover read: "How a New Stock Market Model Predicts the End of the 18-Year Bull Market (1982–2000) and the Beginning of a New Era." The "new era" would be a long-term trading range (roller coaster) market, which materialized between 2000 and 2009. Then, on August 31, 2010, in an SA article titled: "The 10-Year Trading Range Is Over – The 'Final Stampede' Has Begun," he called the end of this market trading range and the beginning of another long-term bull market, which also occurred. Through his company, Sentiment King, he continues to learn and do what he loves—researching and successfully predicting major stock trends—and helping others see them too.
Disclosure: We do not currently hold stock, options, or similar derivative positions in any of the companies mentioned, and we do not expect to open any such positions within the next 72 hours. I wrote this article myself, and it expresses my opinions. I receive no compensation for it (except from Seeking Alpha). I do not do business with any company whose stock is mentioned in this article.
