The Master Sentiment Indicator Still Points To Higher Prices (NDX)

Last week we wrote an article about the short term master sentiment indicator (ST-MSI) becoming neutral as prices slowly trend higher. We explained this could be a problem if the ST-MSI becomes more bullish and the market moves back to 4300. So far it hasn’t.

On the other hand, the long-term master sentiment indicator (MSI), which is a composite made from nine sentiment indicators, continues to point to higher prices. Its two buy signals, one in June and the other October, suggest we have started either a new bull market or an intermediate term move back to last year’s high of 4,800 on the S&P 500. We think it’s the latter and that the market is forming a large ABC corrective wave called a flat (See short video explanation).

The MSI (Master Sentiment Indicator)

We have two master sentiment indicators, one long term and one short term. The long-term indicator, or MSI, has a track record back to 2007. It is a composite made from nine other sentiment indicators. It’s graphed below on the Sentiment King’s ranking scale, which is explained (here).

The MSI is a contrary opinion indicator, meaning that when too many people become bearish, it signals a buying opportunity. The black arrows on the chart show past moments when this occurred.

After reaching extreme bearish readings last June and October, it’s been slowly coming down as the market’s rallied. As one can see it’s currently halfway toward the neutral zone.

In using the theory, one waits for an extreme reading in bearish sentiment. When it occurs it’s a sign to become strongly bullish. One holds this viewpoint until sentiment moves to the other extreme. That could take six months, or four years. Study the chart and you’ll see that, after an extreme bearish reading, the market seldom experiences another major decline without sentiment first becoming bullish again.

So, from the theories point of view, this movement of the MSI out of the extremely bearish area doesn’t signal anything except that the buy signal of last summer continues. We’ll talk more about this at the end of the article; in the meantime we’re going to look at some of the nine components that make up master index.

The nine components of the MSI

This table shows the nine components that make up the MSI and where each currently ranks on the Sentiment King’s scale.

The MSI is composed of two puts and calls ratios from the CBOE, commitment of traders data on the 500 futures, the amount of buying in the ProShares S&P Short fund (SH), the average investment position of the National Association of Active Investment Managers (NAAIM), long term moving averages of Hulbert’s two sentiment surveys of money managers, a time weighted average of the AAII member survey, and the granddaddy of them all, a time weighted moving average of the Investors Intelligence compilation of bullish and bearish newsletter writers.

None of the indicators that make up the MSI are showing any signs of being close to a bullish bias. Let’s summarize a few here.

Three of the nine indicators – the equity puts to calls ratio, buying levels in the ProShares S&P short fund and the AAII survey, are still in the extremely bearish zone. (Note: while bearish sentiment in the AAII survey fell dramatically last week, we use a time weighted moving average of many weeks in our calculation. The MSI is a long-term sentiment indicator; it doesn’t register short-term swings in sentiment).

As the table shows, the position of the National Association of Active Investment Managers on the scale is the furthest along in the transition from bearish to bullish sentiment. The current weekly number from the association shows the managers are 85% invested. Since they can use leverage, the average position can sometimes go above 100%.

We use a four week moving average of the weekly results, and that number has been higher over nineteen years 40% of the time. The red zone represents 10%. This means it will take more time, and higher prices, before it moves into the extremely bullish zone.

Where do we go from here?

The Elliot Wave theory is a fractal theory, which is a well-defined subject in mathematics. While some fractal patterns are completely predictable, many are completely random, while others, like the patterns formed from the ups and downs of the stock market, lie somewhere in between.

From my experience, the up and down patterns formed by the price movements of the market are more unpredictable than predictable. In practice there are simply too many “alternate counts.”

The predictability of the patterns , however, can be improved substantially by integrating market sentiment into the theory. After doing this I believe the chart shown below is the most probable EW pattern to expect.

A massive Elliott Wave flat

I’ll be explaining this in greater detail in a follow up article, but we believe the market is in the process of forming a large Elliot Wave flat. According to Elliot Wave theory, market corrections and bear markets always occur in three price movements called A,B and C.

The “A” wave is the first movement down in price. The “B” wave is the bear market rally, and the “C” wave is the second wave down. The theory is based on the experiential fact that a bear market is almost never one wave down, but two waves down.

A “flat” is a particular type of ABC correction. It’s where the B wave, or the bear market rally, travels all the way back up to the top of the market forming essentially a double top. It then travels back down to the previous low forming essentially a long, sideways movement in the market.

We think the strong bearish sentiment of last year supports the idea that we are in a bear market that will form a large Elliot Wave flat, diagrammed below.