Dynamic Hedge blogs about correlation, relative value and quantitative analysis at http://www.dynamichedge.com
Chart courtesy of SentimenTrader.com.
This study plots the “dumb money confidence,” the “smart money confidence” and the spread between the two. The theory is that smart money will be a buyer during market bottoms a seller into rallies. Dumb money, on the other hand, will enter the market after most of the gains have already been realized and become bearish after most of the decline has already occurred. When the two groups diverge significantly from one another it marks an extreme sentiment reading that should be taken as a contrary indicator.
I’ve highlighted the extreme optimism spread readings since the bull market began in 2009. As you can see, when the market was momentum-driven in 2010 the extreme optimism reading lasted a considerable length of time. The extreme optimism readings mostly led to mostly minor corrections (although some of them were monsters). My point is not to criticize the indicator. In fact, the indicator nailed the bottom of the markets with great consistency since the beginning of the bull run. It also nailed most of the tops during the previous bear market. Obviously the lesson is context. Yes, we are currently at a sentiment extreme, just within a larger context of a bull market. The pullbacks are most likely buying opportunities and sentiment will remain optimistic for extended periods. This is how the market is rolling. Until it doesn’t. Sure, caution is warranted but don’t expect Armageddon around the corner.
This is an amazing indicator and I would highly recommend having Jason Goepfert’s research in your trading toolbox. He’s the man when it comes to quantitative analysis of a notoriously hard-to-quantify subject. An important note about this indicator is that it is calculated using real-money gauges rather than subjective opinion polls.