Sentiment Reaching Extremes Again

In order to improve decision making, we incorporate sentiment readings into the process.  This is an area which is sometimes overlooked, but we think is extremely important.  We believe this is one of the key metrics to use as it helps remove emotion from the overall thought process.  Today we are looking at sentiment readings because they are reaching extremes again.

Now that QE2 has started, corporate earnings have for the most part been better than expected, and the market has rallied - everything seems to be fine, at least according to the latest Investor Intelligence sentiment figures.

Each week the service Investors Intelligence surveys some 140 financial newsletter writers to determine whether they are bullish or bearish in their opinions to subscribers. The resulting Investors Intelligence Survey compiles the data to arrive at a weekly percentage of bulls vs. bears. The Survey is considered a contrarian indicator, since extremes in either direction have historically signaled a reversal of the market’s current trend.

Currently, the readings are just as bullish as they were back at the end of April 2010, right before the flash crash in May and the subsequent drop into July.  While there is no guarantee the markets will decline, given the history of the sentiment readings as a contrarian indicator, it makes sense to be more cautious at this juncture and patiently wait for sentiment to turn more bearish and less bullish.

Below are the most recent charts for bullish sentiment and bearish sentiment along with recent commentary from Investors Intelligence.

Overview 

The election is over and the latest quantitative easing has commenced, with indexes showing remarkable gains since the end of August. That was when the Fed action was first announced and polls forecast the change in Washington, which occurred. Despite the already solid gains near 20% in about 2½ months the latest readings show a lot of advisors apparently “buying the news” as the percentage of bulls soared over 8% the last week. The jump came within a hair of the levels shown in December 2007, which were just below their high of 62% from October 2007. That was the all-time stock market high.

Impact of Quantitative Easing

It continues to seem likely that QE2 will unfold against a backdrop of steadily rising treasury and investment grade bonds yields in the coming months. In a sense the second round of quantitative easing is just the monetary version of “cash for clunkers”, which effectively shifted car sales that would have occurred later in 2008 to the summer months. QE2 may lower yields in the short term but it is unclear that there will be any lasting effect.

The build-up to QE2 has also been characterized by a rapid sell-off in the US dollar, but this is merely a reflection of powerful investment flows rather than a genuine or deliberate debasement of the currency by the Federal Reserve Board. Nobody wants to own an investment that decreases in value. Ironically the US dollar has been notably more robust since the official launch of the QE policy and it is certainly possible that it has marked its lows for the time-being, particularly against major currencies.

The great winner in the QE2 sweepstakes thus far has been the commodity complex with money chasing virtually the entire spectrum. Agricultural commodities have been particularly strong with multi-decade highs recorded in sugar, coffee and spices. In terms of the commodities gold has managed to establish a series of new all time highs over the past few weeks and crude oil has finally managed to break above its multi-month range as it moves toward $90 per barrel.

We would not bet against any portion of the commodity complex at the moment, but are also not particularly tempted to jump aboard a runaway train either.

The Federal Reserve's Explanation

Federal Reserve Chairman Ben Bernanke wrote an article for the Washington Post that was printed in the paper Thursday morning. Below is the link to the article. Very interesting read.

http://www.washingtonpost.com/wp-dyn/content/article/2010/11/03/AR2010110307372_pf.html