What Investor Sentiment Can Tell Us About the Market's Next Move

Traders should be on the lookout for a shift in option buyer sentiment

Senior Vice President of Research
Sep 14, 2020 at 8:41 AM
facebook X logo linkedin

“For bulls, the important takeaway is there is fear in certain parts of this market that represent future buying power, but there is an equal amount of uncertainty as to exactly what moves them into participating in this rally.  And this is why I remind readers that a shift in sentiment among equity option buyers or active investment managers is what could fuel a correction, if the longer-term players are looking for a deep pullback, or if  they remain on the sidelines waiting for some event to pass before making any major commitments to the equity market. “

                -Monday Morning Outlook, August 24, 2020

“Equity funds had estimated outflows of $33.22 billion for the week (0.30 percent of July 31 assets), compared to estimated outflows of $20.97 billion in the previous week. Domestic equity funds had estimated outflows of $20.89 billion (0.25 percent), and world equity funds had estimated outflows of $12.33 billion (0.44 percent).”

                -Investment Company Institute, September 9, 2020

The jury is out as to whether the SPX’s Friday-morning lowat its 40-day moving average marks a trough like it did in June. Coincidentally, the 40-day moving average was in the vicinity of the 3,355 level, which is 50% above the March closing low…. Additionally, the SPX managed to close the week back above its February closing high after a brief move below this level...bulls will breathe easier if the SPX climbs back above the trendline connecting higher lows since the June low, which is around 3,450 as we enter the holiday-shortened week. It battled this trendline into the close on Friday but closed just below it.”

                -Monday Morning Outlook, September 8, 2020

With the Nasdaq 100 Index (NDX--11,087.40) trading more than 10% below its recent closing high, and the S&P 500 Index (SPX--3,340.97) breaking below potential support levels last week that held the previous week, I could not help but think back to comments that I made in late August, regarding the sentiment backdrop and the market’s vulnerability to a shift in sentiment among those that have helped drive it higher. 

Not only did the SPX fail to retake a trendline connecting higher lows since its June low, but it fell below both its February high and its 40-day moving average. These are two of the three support levels I previously highlighted that could potentially cause those that have been bullish on this market to reverse course. A third potential level of support on the SPX remains intact, which is its 2019 close at 3,230.

9-13 chart 1

Mutual fund participants have been skeptical for months, as outflows ahead of the pullback earlier in the year have continued throughout the rally from the March lows. And as of early September, these participants continued to move out of equity funds. While they represent future buying power, the unknown is exactly what it would take to give them confidence to buy stocks. As it stands now, you cannot count on this group to support equities, but it will be interesting to see if the correction in the Nasdaq finally generates inflows when new data comes out this coming week.

On the other hand, equity option buyers were at a historical extreme in terms of being in love with stocks, buying a record number of calls (upside bets) relative to puts (downside bets).  When this group is as positive as they are now, and have been for weeks, short-term trading ranges or pullbacks usually follow. While it isn’t shocking that the market pulled back as this group was at a historical extreme in terms of their bullishness on stocks, the surprise is how long the market took to take them by surprise. 

Moreover, active investment managers were as enthusiastic about equities as they were in years, as is evident by this group moving slightly into leveraged long exposure.    

The enthusiasm among these short-term traders was justified, as the market’s momentum was clearly pointed in a northern direction amid mild pullbacks. But as our sentiment data revealed last week, one group shifted its exposure drastically in a short period, confirming the risk that I had identified, while another group is currently being tested.

A segment of the market that clearly rotated out of stocks is active investment managers, per the weekly National Association of Active Investment Managers (NAAIM) survey, which asks respondents to disclose their net exposure. After moving into a slightly leveraged long position in mid-August, this group aggressively sold stocks last week. In fact, the one-week drop in exposure was the second largest in the history of the survey (a week in January 2008 saw a slightly larger drop). Net exposure at present, while not at an extreme low, is at levels that have defined bottoms on some pullbacks. The jury is out as to whether this group continues to decrease equity exposure to extremes like 2015, 2016, late 2018 to early 2019 and earlier this year.  

9-13 chart 2

Meanwhile, as equity option buyers are not buying as many calls relative to puts as they were at the end of August and into early September, the 10-day, equity-only, put/call volume ratio remains at historical lows. But if this ratio takes out previous short-term peaks amid weak market action, you should be on guard for a sentiment shift similar to that in the NAAIM survey. The implications of such a shift would create a headwind, as either the number of calls being purchased would drop significantly, resulting in market makers demanding less stock to hedge, or a big pickup in put options would create demand for more short positions as market makers look to hedge. 

9-13 chart 3

With the S&P breaking a couple of support levels, the Nasdaq-100 Index (NDX), which is defined by the biggest market capitalization tech stocks, is down more than 10% from its closing high, after a brief move above the 12,000-millennium mark. After a slight break at its 50-day moving average -- a popular moving average that many momentum-based traders lock onto -- and a break below a trendline connecting higher lows since April, the momentum we saw in August is likely not to emerge anytime soon. 

The index is now fighting to remain above the 11,000-millennium mark -- a clear hesitation area two months ago. If this level holds, a retracement is likely in the weeks ahead. If 11,000 breaks, I think a move to at least 10,500 could be imminent.  This level is important, as it is roughly 50 percent above the March lows and represents its 80-day moving average.   

9-13 chart 4

Finally, the CBOE Market Volatility Index (VIX--26.42) pulled back on Friday, but remains above its 252-day moving average. A couple weeks ago, I advised readers to look for a move above this level as a sign that a volatility pop could be imminent, and this occurred without hesitation.

While the VIX peaked on the Friday before the Labor Day-shortened week, it remains above its 252-day moving average, implying there is enough risk in the market that you should keep the hedge you put on when the VIX topped its 252-day moving average, or you should thinking taking advantage of the VIX pullback last week to hedge your long positions.

9-13 chart 5

Todd Salamone is Schaeffer's V.P. of Research

Continue reading:



How to collect 1 dividend check every day for LIFE

Did you know you could collect 1 dividend check every day the market is open? You could also do it starting with just $605! For me, I'm collecting 70 dividend checks every quarter…which averages around 1.1 dividend checks every business day. There's no trading behind this... no penny stocks or high-risk investments. All you do is buy and hold and you're set. There's no set up required either. If you start buying the dividend stocks I show you today... you could collect 1 dividend per day starting as early as this week. Click here for all the details.