Are Bullish Sentiment Extremes Setting up Stocks for a Major Reversal?

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Scanning the media headlines to gauge the "mood of the market" can be a good way to measure public sentiment. As a contrarian, I always like to have a pulse on the media's outlook because it can provide valuable clues to the market's future.

Here are some of the headlines featured recently:

"Dow 15,000 - This bull has room to run"

"Why the Dow could hit 17,000 by year end"

"Buy the Dip, We are going to 16,000"

Based on these experts, it seems obvious the markets are going way up, but unfortunately the markets just aren't that easy.  History teaches us so.

Historically, headlines such as these typically occur closer to market tops than bottoms.  This is similar to 2009's market (VTI - News) lows, when most headlines were extremely bearish (Remember the Dow 5,000 calls?).  If you still aren't convinced, just ask yourself where all these Dow 17,000 headlines were when the Dow (DIA - News) was trading at 7,000 four years ago. 

This is classic returns chasing and recency bias.  My guess is they were singing a similar tune in 2000 and 2007 as well, just before the markets (IWM - News) tanked.

Luckily we have better tools than "experts" exercising their herd mentality.

Bullish Sentiment Extremes In mid-May the market continued to record a number of bullish sentiment extremes, adding to its already all time record. The most recent was the CBOE Equity Put/Call Ratio, which fell to its lowest levels since March 2012 - when the last prominent stock market peak occurred.  Previous to that occurrence,the last time it was at these levels preceded the 2011 20% market pullback.

The chart below provided in our most recent Newsletter shows the extreme levels of complacency shown by options traders.

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But it doesn't stop with the options traders. 

Bullish sentiment as capturedby the II poll and plethora of other polls also are now at their highest levels since April 2011, when the last 20% correction occurred.  

The bullishness as measured by many of these indicators is even approaching or already reached itsall time high readings from the year 2000 and 2007.

The VIX (VXX - News) also sits near its six year low, showing yet another sign of extreme complacency.  Couple all of these sentiment indicators and we have the recipe for a potential major market top brewing.

The table below, featured in the ETF Profit Strategy Newsletter on March 22, neatly summarizes the various sentiment indicators. The Newsletter's simple conclusion was that expectations are so good, it's actually bad. The data "paints a pretty clear picture that sentiment is near or already exceeded the bullish sentiment extremes associated with recent major market tops.  As we often like to say, "the market has legs, but no brains." 

In addition to the summary below we included over 20 more indicators showing similar extremes along with historical references (reserved for subscribers).  Many of those have gotten even more stretched in the two months since.

Turning Data into Profitable Decisions

Sentiment gauges are valuable, but basing decisions merely onsentiment can be dangerous, and basing decisions on fund managers and talking heads who likely don't have your best interest in mind is downright deadly.  For that reason, the ETF Profit Strategy Newsletter also uses technical analysis to help us identify key support and resistance levels as well as spot key trend changes.

Regardless of our longer term view that the markets are nearing a major market top, we let price tell us what to do first and foremost, and then we act accordingly. 

This strategy helped us take advantage of a short term long trade using support levels in our 5/1 ETF Technical Forecast where we advised:

"With price at 1583 (SPY - News) and the pivot only 5 pointsaway this sets up a great high probability long opportunity.  Buying now or near the pivot is the setup".  We also warned, "Although the expectation isfor a market top to be forming, the trend has been up, and from a risk:rewardperspective the long here using the monthly pivot as a stop is a reasonable long trade."

That trade was closed three weeks later on 5/22 for a greater than 4% gain. 

Three items we are now watching and mentioned in our most recent newsletter released Memorial Day weekend:

1) The recent price highs may have been reached a parabolic blowoff top

2) A price level that was gapped through in early May is the keyto the short term uptrend

3) The 1536 price and what it means to the uptrend

How Low could it Go?

The key question now is whether this recent selloff (see Japanese stocks) is merely another opportunity for bulls to reload or have we actually reached the point of exhaustion for bulls. 

Sentiment certainly suggests such an exhaustion scenario could bein play and our assessment made on May 24 in our latest Newsletter was that:"For now we are sitting on the sidelines waiting for the next opportunity,but our longer term feeling remains that the farther this market (QQQ - News) rises from reality, the harder it will fall." 

If the S&P falls below our first key support level, at a minimum, acorrection of the entire move up since November is expected (a pullback to 1550 at a minimum), but potentially a lot more.

The ETF Profit Strategy Newsletter delivers complex technical analysis in an easy to understand manner. Knowing important support/resistance levels gives traders/investors the edge needed to outsmart the markets.

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