Sentiment Is Too Bullish, but I'm Not That Worried

 | Oct 09, 2017 | 6:00 AM EDT
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With the Fear and Greed Index tagging 95 this past week and the Daily Sentiment Index (DSI) at 89, there are two questions I have been asked repeatedly. The first is that Fear and Greed and DSI were here in mid-July and I was quite cautious in mid-July, so why aren't I so cautious now? And the second is related: what would it take to turn me cautious?

I am going to answer the two questions together. Let's start with why the market now looks different than it did in mid-to-late July, when we last saw these similar sentiment readings. Let's begin with one of the easiest charts to see the difference on: The ratio of (IWM) to (QQQ) (small-caps to big caps).

Ratio of IWM to QQQ.

The red line is the line I have been drawing in for a few weeks and highlighted it on Thursday evening. I have said that once the small-caps begin underperforming, I think we would be set for a bout of volatility (the VIX did rise over 10 on Friday as the small-caps underperformed). But the difference between mid-July and now is evident when we look at where this ratio was when sentiment last got so giddy: it was already in a downtrend (red arrow). The reversal only began last week, and it's still not that divergent yet.

One of my complaints in July was not that breadth using the advance/decline line wasn't bad, but rather that up/down volume wasn't so great. Mid July saw a lower high; this latest rally looks much different on the chart.

NYSE cumulative volume.

For Nasdaq, we use the McClellan Summation Index for Volume. The red box shows us July. You can barely see the rally on the chart of the indicator (blue line), but this rally is easily recognizable. It shows more underlying strength.

Nasdaq cumulative volume.

Now, look at the number of stocks making new highs for Nasdaq (NYSE isn't terribly different). The red box shows us mid-July. You can see how different that looks than what we've seen now in terms of expansion.

New highs on the Nasdaq.

Now look at the SOX in mid-July vs now. Mid July was a lower high; today we have a higher high.

Semiconductor index.

Moving on to the Bank Index, we see mid-July had a lower high and even the early August rally essentially stopped where the early July rally stopped. Again, that is not the case today.

Banks index.

By the time the sentiment indicators were extreme in mid-July, the Transports were down 3% already. Here, again, that is not the case (yet!).

Transports index.

There are other indicators as well, such as the Volume Indicator (shown here Wednesday evening) being so stretched (overbought), but not a lower high as it was in mid-July. Or the fact that the 10-day moving average of the put/call ratio had already dipped low and turned up (shown here Thursday evening). It's getting close to doing so now, but in mid-July it had already moved there and was rising.

Put/call ratio.

What does it take to turn me cautious? It begins with breadth. Friday's breadth was terrible for such a modest decline in most of the major indexes, including the small-caps. At -800, it was the worst day since early September. But you see in early September, when breadth was -1200, the S&P 500 ended the day down 18 points, so it made sense for breadth to be weak.

Breadth affects so many of the indicators I use. For example, the McClellan Summation Index stopped going up on Friday. Think about that: the first down day, and the indicator stops going up. Where's the cushion? It will only take +200 advancers minus decliners to turn it back up, but imagine if we see breadth falter for more than a day. Then, the indicator will roll right over, the same way it did in early August (red box).

NYSE McClellan Summation Index.

The Transports tagged 10,000, which I currently assume was just some round number resistance. There is support at 9800 from that uptrend line (green line), but if that uptrend line gives way, that would have me concerned.

If that 10-day moving average of the put/call ratio starts to rise, that would have me concerned (it is close to doing so). If the number of stocks making new highs falls off a cliff, that would have me concerned. That reading peaked this past week at 304 new highs; as of Friday, it was 172. So if the S&P 500 rallies any further and we can't get more than 304 new highs, that is a concern.

As you can see, there are several items on my watch list that have become somewhat shaky, but thus far the indicators do not look as they did in mid-July. They look stretched. Sentiment is too bullish. They need a rest, a pullback, a real dip. But so far, there has been very little selling underneath. If that changes, then I will change. Keep your eyes on breadth. For now, I just expect a bout of volatility based on that chart of the IWM/QQQ ratio.

NYSE overbought/oversold oscillator.

Nasdaq overbought/oversold oscillator.

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