Enter the New Year with Caution Says Sentiment Indicators

The most recent Fed decision injected optimism into the market

Senior Vice President of Research
Dec 18, 2023 at 9:39 AM
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As the SPX probes its July peak, an obvious risk to bulls is a repeat of the late-July through late-October price action… one differentiator is Friday’s candle, with the SPX closing near its high of the day … This is unlike the bearish ‘outside’ day in late July when profit-taking came in heavy at 4,606Another option you can implement in the coming days, if taking the ‘wait and see’ approach, is keying on the SPX with respect to its 20-day moving average before implementing a hedge…Turning to sentiment, I believe that there is life in this rally…”

- Monday Morning Outlook, December 11, 2023

Last week at this time, the S&P 500 Index (SPX – 4,719.19) was trading at the level it had peaked at in late July, preceding a 10% correction into the late-October trough. The uncertainty related to the last Federal Open Market Committee (FOMC) of the year loomed just ahead, which presented a risk, as fed fund futures traders were betting on multiple rate cuts in 2024. This came as many Fed governors held to a message of being “data-dependent,” with rates staying high for a long time as inflation remained above the 2.0% mandate.

As such, even though my technical and sentiment reads bottom-lined to a bullish outlook, I advised that hedging ahead of the FOMC uncertainty given that portfolio insurance, as measured by the CBOE Market Volatility (VIX – 12.28) was cheap. Or, for taking a “wait and see” approach with the SPX trading above support levels, including the sharply advancing 20-day moving average. The idea in the latter option was to allow the index to hint at signs of trouble and if it did, immediately hedge long positions.

Fed releases updated projections from December meeting: sees 2024 Core PCE inflation of 2.4% from 2.6% prior forecast; sees 2024 Fed rates between 4.4-4.9% from 4.6-5.4% prior projection

- Briefing.com, December 13, 2023

“…the question of when will it become appropriate to begin dialing back the amount of policy restraint in place, that begins to come into view and its clearly a topic of discussion out in the world and also a discussion four us at our meeting today

- Fed Chair Jerome Powell, December 13, 2023

Instead of the typical “rates higher for longer” message from the Fed, market participants were treated to a pre-holiday gift with a dovish tone, as Powell admitted that rate cuts were a topic of its meeting and the newest dot-plot of Fed projections saw the anticipated range of the fed funds rate lowered. In response, some viewed this as a Fed pivot from hawkish to dovish.

With many market forecasters warning that a too hawkish Fed could damage the economy or put a major dent in profit growth, the perceived pivot was welcomed, and the SPX easily rallied through its July peak. For those bulls taking the “wait and see” approach on implementing a portfolio hedge, there was no need to act, and this remains the case heading into this week.

This gives them an opportunity to hedge if the SPX moves up to its next major hurdle: its all-time closing high in early January 2022 just below the 4,800-century mark. But if bulls continue to take a “wait and see” approach in terms of looking for evidence of a technical breakdown, they can implement a hedge if the SPX breaks back below the July closing high around 4,590.


Last week, I discussed the cautious warning bells that multiple Wall Street strategists began sounding in late November and how the current sentiment in this group reminded me of their caution in April and May -- caution that ultimately proved too early with the SPX rallying into late July.

Those that have a bearish bias may point to the latest American Association of American Individual Investor (AAII) survey and voice similar caution, suggesting there is too much optimism for stocks to rally.

In the most recent AAII survey, more than 50% of respondents were bullish, the first time the bullish percentage reading jumped over 50% since July 20. This caught my eye, as that reading in July was just ahead of an eventual three-month, 10% correction. Plus, readings above 50% bullish are rare.

For example, in 2016, 2019 and 2022, none of the weekly AAII surveys saw a bullish percentage reading above 50%. And in 2015, only the first survey of that year saw 50% or more of respondents bullish.

As such, I looked at the five prior instances in which the bullish percentage rose to 50% or more in the weekly AAII survey, after at least eight consecutive weeks in which the bullish percentage was below 50%. This has occurred five times since late 2014, with four of those apparent “sell signals” preceding bullish price action one month later.


Another sentiment indicator suggests that short-term option speculators are anything but bullish and, in fact, clearly betting on a reversal of the market’s fortune. This group has been betting against the market for the past month, when looking at five-day open interest (OI) changes on the nearest Friday options on the SPDR S&P 500 ETF Trust (SPY – 469.33). In this case, I used the just expired, December 15 options.


Another sentiment indicator that I find interesting is the level and direction of short interest on SPX component stocks, specifically after the release of short interest data last week as of the end of November. Note in the chart below that that total short interest is rolling over from the highest levels in more than a year.

But the rollover is small, implying short covering was minimal in the month of November. As such, short covering could very much be supportive of the market into year end, even as short-term option speculators bet against the upside action the past several weeks.


Todd Salamone is the Senior V.P. of Research at Schaeffer's Investment Research.

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