- How to use market sentiment to improve probability of portfolio success.
- Is there further downside? Is it too late to sell?
- When should you deploy additional capital?
- Follow my TipRanks public portfolio to see recent performance and current holdings. https://www.tipranks.com/investors/609614/evan-zhou.
We finally had some meaningful profit-taking on Friday (Jan. 31), with the major indices plummeting more than 1.5% each. The media has been buzzing lately with dire news-flow regarding the mysterious Coronavirus. However, this decline in equity prices was already forming before we even knew a Coronavirus existed. I prepared my portfolio for this price shock by paying close attention to several indicators that have proved to be an accurate method to capture alpha through correct tactical asset allocation. I truly believe using sentiment analysis is critical if you’re striving for alpha generation, so I urge you to read on.
There are two metrics that I follow closely, and a careful analysis of both has helped me navigate potential inflection points in the market. See below for a summary of each:
The AAII Bull/Bear spread (Bullish responses subtract Bearish responses) is a time-tested way of gauging the market sentiment during periods of strong upwards or downwards momentum. For those of you who don’t know, the Bull/Bear spread is created from the results of a survey conducted by the AAII. The survey simply asks its members whether they’re bullish, bearish or neutral for the next six months. This information is important because it gives you a crucial wake-up call during emotional times in the market, whether it’s relentless buying or doomsday panic selling. In the short term, stock markets often selectively choose which pieces of information to focus on and quickly discount away the rest. That’s why you’ll notice during periods of strong market performance, all the talking heads will be justifying their aggressive positioning with any type of good news, but when markets start to fall, they’ll suddenly be warning everyone of the same risks that were there the whole time. This type of confirmation bias is extremely easy to fall prey to given our human nature, and this is exactly why we need contrarian indicators like the Bull/Bear spread.
Judging from past data, a Bull/Bear spread of greater than 20% in absolute terms (>20% or <-20%) is a signal for you to reassess your portfolio positioning. If greater than 20%, it means the public is holding a very bullish outlook and therefore you should probably take some risk off, while the opposite is true if it’s below -20%. Before you discount the credibility of these survey results, please have a look at the historical data and compare the periods of extreme sentiment readings versus the S&P 500 performance afterwards.
Notice how the the reading first came in above 20% on the week of Dec. 19, when the S&P was trading at around $3220. This was when I started implementing my de-risk strategy, which took me from a 95% equity weight down to 55% in roughly 3 weeks. Meanwhile the Bull/Bear spread continued to flash above 20% a few more times and the S&P continued its run up by another 3%. But that 3% has been wiped out in less than a week due to the Coronavirus, and because I’ve been selling equity and preparing for this correction, I can start deploying my liquid cash as the market continues to fall.
What the Bull/Bear spread doesn’t tell you? Well first thing is it doesn’t tell you exactly which date or what catalyst will trigger the selloff, and that’s why I mentioned previously this tool should be used to dramatically improve the probability of success in your tactical portfolio asset allocations. Second, this tool does not provide the same meaningful signals when it’s not at the extreme ends, so anywhere between -20% to 20%. During these quiet periods, you need to use other information such as fundamental and technical analysis to try and position yourself correctly.
2.) If sentiment indicators didn’t convince you the equity market was becoming risky, then this analysis might. For as long as the S&P 500 has been in existence, when index prices climbed higher than 8-10% above the 50 week Simple Moving Average, it almost always going into a correction shortly after. The correction could be anywhere from 3% to 20% depending on the technicals and the severity of the triggering event. See below how this time the S&P reached ~11.4% above the 50 week SMA before peaking out. Using this data in combination of the Bull/Bear spread supported my decision to take a risk-off approach when there was still time.
PS: Notice how the RSI is also surging to above 75 on a weekly time-frame, which is extremely rare (5-6 times over the last decade), and usually followed by a selloff.
So is it too late to sell? When do you invest your cash?
If we were more concerned about a potential near-term recession or some other kind of risk that might cripple the economy, then I would say it’s not too late to sell. But that is not the reality we live in. The long-term bullish momentum should still continue as long as the US has a strong economy relative to the world, along with a continuously easy monetary policy. So if you haven’t sold already prior to the Friweek selloff, you’re probably better off by riding this one out.
For those of you who do have liquid cash to invest, here’s how I’m planning to deploy my capital. In a strong uptrend, the S&P will bottom out somewhere between 4%-5% above the 50 week SMA and the SMA itself. Refer to picture below to see the entry points more clearly. Assuming the virus is a transitory event that will pass with time, this level of pullback would be pretty normal based on the myriad of historical data. I will be looking to layer in my investments within the outlined range below.
In case you’re wondering, here is my current allocation in my portfolio.