The Value of Sentiment: A Trader's Take Before The Fed Decision

Schaeffer's Senior Options Strategist Tony Venosa, CMT, shares his thoughts on sentiment, as the Fed prepares its decision

Sep 17, 2015 at 10:51 AM
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    Each day at Schaeffer's, we study several indicators to get a feel for sentiment in the market: the key to our Expectational Analysis® methodology. Such insight can be a powerful tool, helping us locate opportunities by stepping outside the Wall Street box. With a monumental Fed decision on tap, it's as good a time as any to delve into one of Schaeffer's three keys to contrarian trading. Below is a conversation on sentiment with Schaeffer's Senior Options Strategist Tony Venosa, CMT. 

    Q: Give us a sense of how you view and use sentiment, generally speaking. 

    A: I use sentiment in two different ways. First, I like to get a macro view, sentiment-wise, of the overall picture of the domestic broad market. I am trying to get a sense of how the crowd is currently positioned in the market and apply a contrarian approach. Using such indicators as the International Securities Exchange (ISE)/Chicago Board Options Exchange (CBOE)/NASDAQ OMX PHLX (PHLX) equity-only put/call volume ratio, total short interest data on the S&P 500 Index (SPX), Nasdaq-100 Index (NDX), and Russell 2000 (RUT) stocks, and some of the popular sentiment surveys, to name just a few, helps me determine a feel of the overall emotion in the market place. Popular online media publications are another, more subjective tool to gauge sentiment. Reading articles from The Wall Street Journal, Barron’s, Yahoo! Finance, and CNBC are mainstream enough to aid my sentiment studies.

    The second way I use sentiment is determining the way the crowd is thinking about individual companies. Again, I use a broad array of sentiment measures, such as buy-to-open put/call volume ratios, short interest data, open interest configurationsanalyst ratings, and magazine cover stories.

    Q: Are there times when we should take sentiment studies/readings with a grain of salt? 

    A: There are always times when we should take sentiment studies with a grain of salt. Studies and indicators will never give the trader a black or white answer on whether to be long or short. It’s a matter of interpretation and probabilities. For example, a simple popular indicator such as the Relative Strength Index (RSI) may indicate a stock is overbought when the RSI exceeds a reading of 70. But as one finds out, this does not mean immediate action must be taken. A stock can remain in an overbought condition for a long time. The same is true for sentiment indicators. An indication of extreme pessimism does not equate to a buy signal.  

    Q: What's your favorite gauge for sentiment in the market? 

    A: My favorite gauge to determine sentiment in the overall market would have to be the 10-day average equity-only put/call volume ratio and the one-day equity-only put/call volume ratio. Both can determine good levels of fear and greed in the market, of which I find more reliable than most. These measures are actually good reflections on what speculators are actually doing with their money as opposed to something like a sentiment survey.
    Q:  What are your thoughts on the latest Investors Intelligence (II) sentiment survey, specifically? 

    A: The latest results from the Investors Intelligence (II) survey shows a definite extreme in pessimism among advisors. The percentage of bulls reads 26.8%, which is near the lowest level since December 2008. The bulls-minus-bears line has experienced seven straight decreases and is also at a level not seen since 2011. Based on our research, we have found the market has positive returns on a one-week, two-week, four-week, and eight-week time period going for forward, when the bulls-bears percentile was this low.

    Q: What role do you think sentiment will play in the post-Fed reaction, if at all? 

    A: I think sentiment will play a vital role in the post-Fed reaction. I do not necessarily mean the immediate reaction, because there will be a lot of noise when the news hits.  After the dust settles, so to speak, sentiment will play a part in determining the next big swing in the market. And it does factor in a major way for me. Currently, there are plenty of conflicting viewpoints on whether the Fed will raise rates or not, which can be quite confusing. But I think the more important question to focus on is what will the market reaction be. And sentiment can help us determine that.

    My assessment is the crowd appears to be positioned for a major downswing. Small speculators in index futures are net short to one of the highest points in a long time. The equity-only put/call volume ratio is showing major put buying relative to call buying at an extremely lopsided level. The pain trade -- i.e. the trade where the crowd is very one-sided -- seems to be the long side. A Fed rate hike -- or not -- may not matter at all. If people are sure the market will go down and we get an upside reaction, there may be a lot of pain felt by these bears. A scramble for the door may squeeze this market higher in the next month or so, trapping a lot of shorts.

    Q: Since we use sentiment as a way to invest from a contrarian standpoint, let me ask: Is being contrarian beneficial in other areas -- possibly fantasy football? Asking for a friend. 

    A: I think being a contrarian is beneficial in a lot of areas of life, be that fantasy football, speculating, poker, or even politics. I think the main point I want to express is, in order to excel at something, you must think for yourself and try to differentiate yourself from popular or feel-good viewpoints, because most often they are wrong.  

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