The stock market's latest pullback has some bulls on edge. After an uninterrupted rally that started in November, the recent pullback deleted 5% of gains and has thus far become the largest correction since then.My article "Are Technicals Signaling a Storm Ahead" already suggest a heightened sense of insecurity, and now I'm watching a few key things concerning market sentiment (or mood of the market) to keep us ahead of a deeper correction. How to Use Sentiment DataIf I told you that a certain penny stock trading on the Nasdaq (NYSEARCA:QQQ) hit record highs in May 2013, you likely would dismiss it and say so what? I most certainly would, mainly because we have no clue if the stand alone data is meaningful information or not. But if I told you that the amount of aggregate tradng in penny stocks just surpassed the previous peak levels that occurred in Feb 2000 (coinciding with the Nasdaq's all time price high), we start to get a better idea of how the data can be helpful. By itself it may not be meaningful, but when compared to the same data throughout history, it can be eye-opening, especially in recognizing extremities. This is how a lot of sentiment analysis works. The Nasdaq penny stock action is really put in perspective when it is revealed that typically penny stock volume peaks at market peaks and bottoms at market bottoms. The below table and simple chart of the Nasdaq (NYSEARCA:QID) captures the penny stock volume at recent major market peaks and troughs (in red). A pickup in penny stock action on the Nasdaq (NYSEARCA:PSQ) may be warning of a topping market as speculators again go to extremes chasing penny stocks and a rising market's trend.
The Bigger PictureThis is just one sentiment example and may just be coincidental and not proving anything, which is why in the April ETF Profit Strategy Newsletter I looked at over 25 other sentiment indicators to get a better idea of current levels compared to historical market peaks and troughs.An example of that report is shown below with a key takeaway that almost all sentiment indicators have reached or were again very near their all time high bullish levels recently. This data overwhelmingly shows that the market (NYSEARCA:VTI) was likely much closer to a major long term selling opportunity than a major buying opportunity.Three of the many popular adviser surveys are shown below as they were included in the Newsletter analysis. Two of the three recently reached their all time high bullish levels and the third was in the upper levels of its historical past. By comparing the levels associated with market tops to levels associated with the 08-09 low it is clear that there is a distinguishable difference between bullishness during market tops and bearishness during market bottoms. Advisors in these surveys become most bullish near market tops and most bearish near market bottoms, exactly opposite of what they should be.
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We summarized our findings by saying, "Sentiment can be a very powerful driver of share prices (NYSEARCA:IWM) as the herding mentality of investors can takeover near market tops and bottoms. Being able to recognize such times in history can help you stay clear of irrational investment decisions."Abenomics and SentimentJapan's recent market rise was accompanied by record smashing bullish sentiment as measured by the Tokyo Stock Exchange's margin and commitment of traders (COT) data. For only the second time in history Japanese margin traders as a whole actually carried net positive positions (profitable). Moreover, large speculators were the net longest they have ever been since at least the early 90's. Typically these traders are considered the "dumb money" because over the long run they are usually on the wrong side of the trade. No doubt, this would not last, and it didn't.We knew sentiment was ripe for a major reversal in the Japanese stock market's (NYSEARCA:EWJ) uptrend and that a reversal in the positions of the long margin traders and speculators would lead to a deep Japan (NYSEARCA:DXJ) decline, we just needed to wait for price to confirm the trend change before we could capitalize on the price and thus sentiment reversal.
On 5/22 that trend reversal occurred and on 5/29 we advised going short the Japanese market in our Weekly ETF pick by buying the ProShares UltraShort Japan ETF (NYSEARCA:EWV). We also recommended put options. EWV was at $21.17 then and rose above $23 within a week in a great example of how a shift in sentiment can move the markets very quickly.
What to Expect
With sentiment in the U.S. markets having already reached peak bullishness it is likely the majority of buyers have now already bought in. This means the risk is now likely to the downside. With the recent pullback in price, we may finally be seeing the technical picture breakdown. Next to follow would be overall sentiment deterioration that would drive prices lower.
Once two key price levels I am watching are breached to the downside, it is likely the large amount of bulls will start to reverse their positions and switch their overall sentiment to a more neutral or bearish stance, just as the Japanese market is doing now.
The ETF Profit Strategy Newsletter focuses on fundamentals, technicals, sentiment, and common sense to follow the world's markets. We publish a twice weekly Technical Forecast and weekly ETF Picks to stay ahead of key trends and turning points. Follow us on Twitter @ ETFguide