Some of the contrary indicators we track are themselves giving contradictory signals. When combined with the strong internals of the market, this suggests that while there is more upside from here, the market may need to gather itself up for the next leg up.

The biggest danger is the excessively optimistic viewpoint revealed by recent sentiment surveys. The II survey now shows 58.7% bulls (vs. 56.5) and 16.3% bears (vs. 20.7), or 3.6 Bulls for every Bear. That extreme level of sentiment begs the question: “Who else is left to buy?”

Self reported sentiment indicators (such as this one) come with a caveat: They are external to the markets, rather than internal; In other words, they are not a function of price and volume over time; As such, they are once removed from actual market action. Jason Goepfert (sentimentrader.com) notes that “since 1969, each of the other times the bearish percentage dropped this low, it stayed that way for many weeks or MONTHS on end. A single such reading is not enough to sell stocks en masse, but it should at least raise a caution flag.” We agree.

On the other side of the ledger is the Smart Money Index (see chart at right). The SMI is based upon the principal that the first 30 minutes of trading is emotionally based. It’s reflective of all the “hype” which came out from between yesterday’s close up and today’s open. The early trading is considered “dumb” money; The last hour’s trading, on the other hand, is based primarily on more contemplative factors; Its considered the “smart” money.

The SMI suggests that since the 2002 Summer lows, institutional money has been quietly accumulating stocks. Although it peaked during the recent March ’03 lows, it has since maintained relatively high levels. When the SMI is upwardly sloping while the DJIA makes new highs, it confirms the Dow’s rise, suggesting more upside remains. The danger sign comes when the SMI diverges: When the Dow make makes new highs, but the SMI is dropping, that’s a signal that institutional “smart” money is quietly leaving the field.

Although the sentiment readings give us pause, we continue to be encouraged by the SMI that this rally is not yet done.

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Quote of the Day: “It is apparent that the public preference for stocks is not only as marked as ever, but also, the will to speculate is still a speculative factor not to be overlooked. The prompt return of huge speculation and the liberal manner in which current earnings are again being discounted indicates that it will be difficult to quench the fires of stock market speculation for long.” -Barron’s “The Trader” column, March 24, 1930

Category: Finance

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