- Interim Update 8th March 2017

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Revisiting the limitations of sentiment

It was only three months ago* that we last discussed the limitations of sentiment as a market timing indicator, but we are revisiting the topic today to mention an additional pitfall and a more topical example.

It's important to state up front that despite the associated pitfalls, it can definitely be helpful to track the public's sentiment and use it as a contrary indicator. This is because most participants in the financial markets get swept up by the general mood. They end up buying into the idea that prices are bound to go much higher despite valuations having already become unusually high or the idea that prices will continue to slide despite current valuations being unusually low. This causes them to be very optimistic near important price tops and either very pessimistic or totally disinterested near important price bottoms.

It will always be this way because 1) a major price/valuation trend can't end until the fundamental story behind the trend has been fully embraced by 'the public', and 2) the public's own buying/selling shifts the probability of success. For example, when the public gets enthusiastic about an investment its own buying pushes up the price of the investment to the point where future performance is guaranteed to be poor. Consequently, there is no chance that the investing public can ever collectively enter or exit any market at an opportune time.

There are, however, three potential pitfalls associated with using sentiment to guide buying/selling decisions.

The first is linked to the reality that sentiment generally follows price, which makes it a near certainty that the overall mood will be at an optimistic extreme when the price is near an important top and a pessimistic extreme when the price is near an important bottom. The problem is that while an important price extreme will always be associated with a sentiment extreme (extreme optimism at a price high and extreme pessimism at a price low), a sentiment extreme doesn't necessarily imply an important price extreme. For example, if the price of an investment has been trending strongly upward for many months and is at an all-time high then sentiment indicators will almost certainly reveal great optimism even if the upward trend still has a long way to go. It is therefore dangerous to take large positions based solely on sentiment.

The second potential pitfall associated with using sentiment to guide buying/selling decisions is that what constitutes a sentiment extreme will vary over time, meaning that there are no absolute benchmarks. Of particular relevance, what constitutes dangerous optimism in a bear market will often not be a problem in a bull market and what constitutes extreme fear/pessimism in a bull market will often not signal a good buying opportunity in a bear market. In other words, context is critical when assessing sentiment. Unfortunately, the context is always a matter of opinion.

We have mentioned the above sentiment issues many times over the years, but there's a third potential pitfall that we don't recall mentioning in the past. It mainly relates to the sentiment indicators that are based on surveys.

Regardless of what the surveys say, there will always be a lot of bears and a lot of bulls in any financial market. It must be this way otherwise there would be no trading and the market would cease to function. As a consequence, if a survey shows that almost all traders are bullish or that almost all traders are bearish it means that the survey has a very narrow focus. In other words, the survey must be focused on a small fragment of the overall market.

There is no better example of sentiment's limitations as a market timing indicator than the US stock market's performance over the past few years. To show what we mean we'll use the results of the sentiment survey conducted by Investors Intelligence (II), which has the longest track record** and is probably the most accurate of the stock market sentiment surveys.

The following chart from Yardeni.com shows the performance of the S&P500 Index (SPX) over the past 30 years with vertical red lines to indicate the weeks when the II Bull/Bear ratio was at least 3.0 (a bull/bear ratio of 3 or more suggests extreme optimism within the surveyed group).

Notice that vertical red lines coincided with most of the important price tops (the 2000 top was the big exception), but that there were plenty of times when a vertical red line (extreme optimism) did not coincide with an important price top. Notice, as well, that optimism was extreme almost continuously from Q4-2013 to mid-2015 and that following a correction the optimistic extreme had returned by late-2016.

In effect, sentiment has been consistent with a bull market top for the past 3.5 years, but there is not yet any evidence in the price action that the bull market has ended.



The bottom line is that sentiment can be a useful indicator, but it does have serious limitations. It is just one medium-sized piece of a large puzzle.

    *In the 5th December 2016 Weekly Update
    **The II sentiment data goes back to 1963

Commodity and T-Bond prices are breaking out to the downside

Commodities

The gold price has broken below support at $1220, but gold is fundamentally different from every other commodity and is always considered separately in these pages. When we use the word "commodity" we are referring to things that are consumed, such as oil or copper or soybeans or cocoa or cotton. Our main concern is usually with what we refer to as the industrial commodities, a category that includes the energies (oil, natural gas, coal, etc.) and the industrial metals (copper, zinc, etc.). Oil and copper, two of the most important industrial commodities, have just broken out to the downside on their respective price charts.

With regard to the oil market, this is how we concluded a brief discussion in the latest Weekly Update:

"We see the potential for oil to quickly move up to $58-$62 before making a multi-month top, but we expect it to be trading substantially lower in three months' time.

Note that a daily close above $55 would be an upside breakout and a daily close below $51 would be a downside breakout. A downside breakout would suggest that a multi-month top was already in place."

A downside breakout (a daily close below $51) happened on Wednesday 8th March. It therefore looks like oil's rally from its November low ended last month and that an intermediate-term decline has begun. We doubt that this decline will result in the January-2016 low being tested, but we expect to see oil trading below $40 within the next three months.

As an aside, oil's rally from its early-November low was linked to the stock market's rally, so the evidence that oil's rally is over adds to the reasons to be concerned about short- and intermediate-term downside risk in the stock market.



With regard to the copper market, a definitive breakdown would require a daily close below lateral support at $2.60, which hasn't yet happened. However, the daily close below the 50-day MA on Tuesday 7th March is a warning that a breakdown is coming.

Below $2.60 there is strong support at $2.45 and in the low-$2.30s. We won't be surprised if the price rebounds from $2.60 to as high as $2.70, but we suspect that an intermediate-term decline is underway and that the price will fall at least far enough within the coming three months to test the lower of the aforementioned support levels.

Note that this bearish short-to-intermediate-term outlook for copper applies to industrial metals in general, as they are mostly in sync with each other (as is often the case).



Treasury Bonds

In the latest Weekly Update, we wrote:

"...the recent price action in all markets, not just the bond market, opens up an alternative possibility. The alternative is that there will be a plunge in TLT [the iShares 20+ Year Treasury ETF] to well below its December low before a substantial counter-trend rally gets underway.

With reference to the following chart, important support lies at 118 and important resistance lies at 122. A daily close above 122 would point to a rally extension to as high as 128-130, while a daily close below 118 would suggest that the alternative scenario mentioned above was in play."

TLT closed slightly below 118 on Wednesday 8th March, so the alternative scenario appears to be in play.



We expect that if TLT breaches its December-2016 bottom then bond market weakness (rising interest rates) will become a big problem for the stock market. In other words, we could soon have even more reason to be concerned about downside risk in the stock market.

The Stock Market

The US

Did SNAP ring a bell?

The founders of Snap Inc. (SNAP) rang the NYSE opening bell a week ago, but the above question pertains to whether the listing of SNAP at a blatantly ridiculous valuation and the rocketing of the share price to a premium of 50% to the aforementioned ridiculous valuation during the first two days of trading marked an important top.

The absurdity of the company's market valuation is underlined by it supposedly being worth:

a) About 65-times annual sales revenue

b) About the same as eBay

c) About 3-times as much as Twitter

This is despite the company being spectacularly unprofitable. So unprofitable, in fact, that for every one dollar of sales, it loses more than one dollar (its annual losses are greater than its annual sales revenue). And yet, the IPO was apparently about 10-times oversubscribed!

SNAP's IPO valuation and subsequent trading performance are such obvious signs of excess that it may well represent the proverbial bell that rings to announce a market top. It probably didn't 'announce' a major top, but it could well have ushered in a top that holds for at least a few months.

Current Market Situation

The SPX has pulled back from its 1st March high of 2401, but it has been a very minor correction to date. It could evolve into something far more significant, but there could also be a surge to a new high within the coming 1-2 weeks prior to the start of a far more significant correction. Either of these possible outcomes would be consistent with our expectations.



Emerging Market Equities

EEM (the iShares Emerging Markets ETF) is a proxy for "emerging market" equities in US$ terms. It reached its peak for the year of US$39.15 on 23rd February. Interestingly and as shown on the following daily chart, the February peak coincided with a trend-line drawn through the 2014 and 2015 peaks.

The pullback from the February peak is minor to date but will start to look significant if there's a daily close below $37.



Downward trends in EEM tend to be driven by at least one of the following:

1) Strength in the US$

2) Weakness in commodity prices

3) Weakness in the US stock market

Our favoured 1-3 month scenario encompasses all three of the above, so we perceive substantial downside risk in EEM. That's why, as mentioned in the past few Weekly Updates, we have purchased June EEM put options for our own account.

Our purchase of EEM puts was made primarily for hedging (that is, insurance) purposes, but a position in EEM puts could also be a reasonable speculation for traders who are familiar with options.

We have added an EEM June-2017 $35 put-option position to the TSI Stocks List based on the expectation that EEM will drop to $34 or lower within the coming three months. The closing price for this option on Wednesday 8th March was US$0.46 while the closing bid-offer spread was $0.50-$0.55. For record purposes we'll take the middle of the bid-offer spread, that is, $0.525, as our starting price.

It would be reasonable to set a daily EEM close above $39.15 as an initial stop for this trade.

Gold and the Dollar

Gold

In the latest Weekly Update, we wrote:

"...we now have a preliminary signal that a short-term top is in place [for the US$ gold price]. Furthermore, given the bearish divergence in the HUI/gold ratio in the weeks leading up to last week's reversal in the gold price it's likely that the preliminary signal of a top will be followed by a more conclusive signal.

A more conclusive signal would be a daily close below lateral support at $1220, which could happen as soon as this week but might not happen until late-March or early-April."

The gold price closed below $1220 on Tuesday and extended its decline on Wednesday, so the more conclusive signal of a short-term top is now in place.



Both gold and silver reached their 50-day MAs on Wednesday 8th March and the gold-mining stocks have begun to show some resilience, which suggests the potential for a rebound over the next few days. However, this is not something to bet on, because despite the recent sell-off the short-term risk/reward is far from bullish. Furthermore, after shifting far enough in a bullish direction to turn neutral a few weeks ago, the fundamental backdrop is back to being gold-bearish thanks to the recent rise in real US interest rates (as indicated by TIPS yields).

We think that a better buying opportunity is coming and would view significant near-term price strength as an opportunity to do some additional hedging.

Gold Stocks

The HUI extended its decline over the first three days of this week, although it held up fairly well considering the weakness in metal prices. It has now fallen far enough that its 50-day MA should act as a ceiling during the next significant rebound.



A test of the December-2016 low (160) looks inevitable, but there are many paths that could be taken to get there. For one example, with the market now 'oversold' there could be a rebound to as high as 200 before the downward trend resumes. In this case, the December-2016 low wouldn't be tested until April or May. For another example, there's a risk that panic will soon set in, leading to the December-2016 low being tested within the coming fortnight.

Of the two possible paths mentioned above, the latter would be the easier to trade. This is because the intense emotions associated with a panic sell-off create buying opportunities that are both terrific and obvious for anyone with plenty of cash who 'keeps their head'.

The Currency Market

The Dollar Index is again challenging resistance at 102. This is the resistance that must be decisively breached to remove the remaining doubt that a correction low was put in place in early-February.



The stage is set for the market reaction to the monthly US Employment Report on Friday 10th March to clearly signal whether or not the US$ correction that began in December is over. It is probably over, but a failure to end this week above 102 would leave open the possibility of a decline to as low as the 200-day MA (currently at 98.1) prior to a correction low.

Note that the coming Employment Report will have to be extremely weak or extremely strong to have any effect on market expectations regarding the Fed's likely actions.

Updates on Stock Selections

Notes: 1) To review the complete list of current TSI stock selections, logon at http://www.speculative-investor.com/new/market_logon.asp and then click on "Stock Selections" in the menu. When at the Stock Selections page, click on a stock's symbol to bring-up an archive of our comments on the stock in question. 2) The Small Stock Watch List is located at http://www.speculative-investor.com/new/smallstockwatch.html

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html