SentimenTrader fanboy

Reading Jason Goepfert's daily comments today made me once again appreciate what a awesome service he provides his subscribers. Almost every post is rich in quantitative analysis, including a historical study or two relevant to today's market conditions. His comments and analysis is always calm, rational, and based on non-data-mined market precedent.

It also blows me away how freakin busy Goephert must be - you can tell he's extremelyh passionate about the markets and his site is a gianorimic dashboard of sentiment indicators.

I only subscribe to a couple services/publications, but sentmentrader.com is the one I truly value.

note - I recieve no financial benefits or discounts from either Sentimentrader.com or Jason Goepfert.

Oscillator funfest

If you're a counter-trend trader, you're probably scanning for a long set-up somewhere in equities. The S&P 500 chart above shows three popular oscillators and illustrates the aftermath of oversold conditions during the past three years. As you can see, buying at oversold junctures during the bull market was a profitable tactic. As we moved into the '07-'08 bear market, gains were usually short-lived. Even so, an oversold condition that is reversing usually signals risk is minimal, at least for the short term.

All three oscillators are currently locked and loaded for buy signals.

A patient model

My gut reaction to periods like this is usually a lot more bullish than my model suggest. We're six weeks into steadily falling prices and sentiment is growing more pessimistic every day. but my model is patient.

By design, my model's sentiment indicators gradually counter trend indicators at market bottoms. A pure trend-following system would always be wrong at tops and bottoms, only to suggest shifts in long/short positions after prices have made significant moves.

As you can see in the screenshot of my model, all four trend indicators are currently at a -1. The sentiment indicators are only slightly bullish, most at a +.5. I score each sentiment indicator slightly different, but the basic principle is:

• If sentiment is exhibiting excessive pessimism but falling, score it mildly bullish
  
• If sentiment is at historical extremes, score it bullish


• If sentiment is excessively pessimistic, but has reversed, begining to show greater optimism, score it as extremely bullish

In my model, trend and sentiment counterbalance each other - yin yang if you will. Usually the sentiment indicators only start to exert bullish weight when the market is growing closer to a market top or bottom. If sentiment reverses, their weighting increases dramatically.

Note the week ending 3/28, where the sentiment indicators went into hyperdrive, overpowering the unanimously bearish trend indicators to push the model to a 70% equity allocation. If you recall that period, most pundits were waiting for the other shoe to drop. Models that include a strong sentiment components can very often get your long/cash allocation right at important turning points.

Below is a chart of my timing model's equity allocation for 2008 vs. the S&P 500.

I Like U.S. T-Bonds

I Like U.S. T-Bonds...as a short/intermediate term trade. There's excessive levels of pessimism towards U.S. long bonds right now, even though they've been able to maintain their current uptrend. I'm taking a small position in GVPIX tomorrow.

I think I see the fat lady coming

My Tactical Asset Allocation portfolio is only 50% long right now, but I'm taking a speculative position in UCPIX today because of the mounting negatives. I'm going to use a pretty tight mental exit - the S&P 500 200 day moving average. Granted, if this much followed moving average is breached we're likely to see good follow through, but I'm up to the challenge.

The market negatives are:

• short term NASDAQ sentiment is OB
• intermediate term sentiment is becoming excessively over optimistic
• OB MACD during a presumed bear market
• NYSE relative volume has been low for the past several weeks
• option expiration week seasonality bias towards short term losses
• we're at the beginning of "sell in May" seasonality
• anything else?

Week of 4-27-2008

Timing Model = 1.5
80% long, 20% cash

Global allocation of long positions
MSCI EAFE Index 30%
MCCI Emerging Markets Index 30%
Russell 3000 Index - U.S. 40%

Top U.S. Sectors
U.S. Oil Equipment, Services & Distribution 5.0
Precious Metals 3.5
U.S. Biotechnology 3.5
U.S. Oil & Gas 3.5
U.S. Real Estate 2.5
U.S. Leisure Goods 2.5

Top Intl. ETFs
S&P Latin America 40 Index Fund 3
MSCI Brazil Index Fund 3
MSCI Taiwan Index Fund 2
MSCI Mexico Index Fund 1
MSCI Canada Index Fund 1
MSCI Emerging Markets Index Fund 1
FTSE/Xinhua China 25 Index Fund 1
MSCI Sweden Index Fund 1
MSCI Spain Index Fund 1
MSCI Hong Kong Index Fund 1
MSCI Belgium Index Fund 1

Strategy 3
Money Market 12.5%
Agriculture 12.5%
Precious Metals 12.5%
U.S. Long Bonds 12.5%
Industrial Materials 12.5%
Energy 12.5%
Emerging Markets 12.5%
U.S. REITs 12.5%
EAFE 0.0%
U.S. Large Cap 0.0%
U.S. Small Cap 0.0%
Intl Real Estate 0.0%

My timing model continues to lose points as pessimism burns off from the bottom we saw in early March. Unless the S&P 500 and Value Line composite breach their 200 day moving average fairly soon, I expect my timing model to continue to shed exposure to equities.

U.S. REITs have just broke above their 200 day moving average and have earned a long postion in strategy 3. Let's see how long that lasts.

1400

I'm not a huge advocate of chart reading, but it seems the 1400 on the S&P 500 has developed special significance over the past 9 months. From August of last year to early January of '08, 1400ish was an area of support. However, since late January, 1400 has been unbreached. This is nothing more than a curiosity for me - I don't make timing decisions based on "support" or "resistance", but I do find stuff like this interesting.

The more important timing considerations are; how quickly will the excessive sentiment we saw in early March burn off? AND how quickly will the short term uptrend in the major indexes reverse?

I'm a follower, not a prognosticator. All I can do is follow the yin yang of my sentiment and trend tools.

Watching for a trend reversal

Yesterday the Value Line Composite Index closed above it's 75 day moving average. The 75 dma of the Value Line is one of four trend indicators in my timing model. If this index can stay above this level today it will raise my model reading from a +1 to a +2, suggesting a 90% allocation to stocks. The S&P 500 is still below it's 75 day moving average.

I point this out because my model is set up to defer to it's trend indicators as bullish (extreme pessimism) sentiment readings begin to lose strength/relevance. The trend indicators will either kick in or the model will begin to turn bearish. My guess is we will see some consolidation near term, but we will head to higher levels over the the next month or so. I also believe we are still in a bear market but my model has an intermediate term orientation, so it is possible to go heavily long.

Trend indicators are very sensitive and whipsaws should be expected. I usually deal with junctures like this by shifting some assets to a double long fund (such as ULPIX) instead of opening a new position in a sector or country ETF. By holding small positions in double long/short funds I can adjust to small changes to my model without generating a bunch of trades.

Here's an under the hood look at my TAA portfolio as of yesterday's close:

Week of 3-30-2008

Timing Model = 1
70% long, 30% cash

Global allocation of long positions
MSCI EAFE Index 20%
MCCI Emerging Markets Index 30%
Russell 3000 Index - U.S. 50%

Top U.S. Sectors
U.S. Oil & Gas 6.0
U.S. Oil Equipment, Services & Distribution 5.0
Precious Metals 4.5
U.S. Basic Materials 4.0
U.S. Biotechnology 2.5
Composite Internet 2.0
U.S. Industrials 2.0
U.S. Semiconductor 2.0
U.S. Technology 2.0

Top Intl. ETFs
S&P Latin America 40 Index Fund 3
MSCI Taiwan Index Fund 2
MSCI Brazil Index Fund 2
MSCI Mexico Index Fund 2
MSCI Canada Index Fund 1
MSCI Emerging Markets Index Fund 1
MSCI Spain Index Fund 1
MSCI Malaysia Index Fund 1
FTSE/Xinhua China 25 Index Fund 1

Strategy 3
Money Market 20.0%
Agriculture 20.0%
Precious Metals 20.0%
U.S. Long Bonds 20.0%
Industrial Materials 20.0%
Emerging Markets 0.0%
EAFE 0.0%
U.S. Large Cap 0.0%
U.S. Small Cap 0.0%
U.S. REITs 0.0%

The sentiment indicators have single handedly pushed my timing model to a point where the equity allocation is now at 70%. I still believe we've seen the intermediate low for the cycle and the market is more likely to head higher over the next several weeks...maybe longer.

Week of 3-23-2008

Timing Model = 0
50% long, 50% cash

Global allocation of long positions
MSCI EAFE Index 20%
MCCI Emerging Markets Index 30%
Russell 3000 Index - U.S. 50%

Top U.S. Sectors
U.S. Oil & Gas 6.0
U.S. Basic Materials 3.5
U.S. Semiconductor 3.0
U.S. Technology 3.0
U.S. Industrials 3.0
U.S. Oil Equipment, Services & Distribution 2.5
U.S. Consumer Goods 2.5
Precious Metals 2.5

Top Intl. ETFs
MSCI Taiwan Index Fund 3
S&P Latin America 40 Index Fund 2
MSCI Brazil Index Fund 2
MSCI Mexico Index Fund 2

Strategy 3
Money Market 25%
Agriculture 25%
Precious Metals 25%
U.S. Long Bonds 25%
Industrial Materials 0.0%
Emerging Markets 0.0%
EAFE 0.0%
U.S. Large Cap 0.0%
U.S. Small Cap 0.0%
U.S. REITs 0.0%

Classic bottom

Once again, I believe we're in the neighborhood of an intermediate low. The combination of sentiment models and momentum divergence gives a pretty strong case. Btw, I don't believe the bear market is over quite yet.

Week of 3-16-2008

Timing Model = -.5
40% long, 60% cash

Global allocation of long positions
MSCI EAFE Index 40%
MCCI Emerging Markets Index 20%
Russell 3000 Index - U.S. 40%

Top U.S. Sectors
U.S. Oil & Gas 5.5
U.S. Oil Equipment, Services & Distribution 5.5
U.S. Biotechnology 4.5
U.S. Basic Materials 4.0
Precious Metals 3.5

Top Intl. ETFs
S&P Latin America 40 Index Fund 3
MSCI Brazil Index Fund 3
MSCI Canada Index Fund 2
MSCI Emerging Markets Index Fund 2
MSCI Spain Index Fund 2

Strategy 3
Money Market 25.0%
Agriculture 25.0%
Precious Metals 25.0%
Industrial Materials 25.0%
Emerging Markets 0.0%
EAFE 0.0%
U.S. Large Cap 0.0%
U.S. Small Cap 0.0%
U.S. Long Bonds 0.0%
U.S. REITs 0.0%

Is the bear tired?

I think so.

The combination of recent market action (multiple selling climaxes) and favorable sentiment readings (short term indictors are OS, and the intermediate term indicators are rising from OS) spell a rally based on my experience.

I just took a couple decent sized positions in 2x funds but will be using a mental stop 1% below the recent lows in case I'm wrong.

Is the bull market over? No, I don't believe so, but bear market rallies should be expected and can be taken advantaged of if you're both patient and nimble.

Week of 1-27-2008

Timing Model = .5
60% long, 40% cash
10 day moving average: 56% long, 44% cash

Global allocation of long positions
MSCI EAFE Index 40%
MCCI Emerging Markets Index 10%
Russell 3000 Index - U.S. 50%

Top U.S. Sectors
U.S. Basic Materials 5.0
Precious Metals 4.5
U.S. Oil & Gas 4.5
U.S. Biotechnology 3.5
U.S. Health Care 3.5
U.S. Oil Equipment, Services & Distribution 3.5

Top Intl. ETFs
MSCI Brazil Index Fund 3
MSCI Malaysia Index Fund 3
MSCI Hong Kong Index Fund 2
S&P Latin America 40 Index Fund 2
FTSE/Xinhua China 25 Index Fund 2

Strategy 3
Money Market 33.3%
Agriculture 33.3%
Precious Metals 33.3%
Emerging Markets 0.0%
Industrial Materials 0.0%
EAFE 0.0%
U.S. Large Cap 0.0%
U.S. Small Cap 0.0%
U.S. Long Bonds 0.0%
U.S. REITs 0.0%

I appologize for the week gap in posting updates. I was on a winter campout over last weekend and didn't have the time this week to run updates.

The sentiment indicators alone have pushed my timing model above zero and thus my long exposure now hovers around 60%. Emerging Markets is now underweight but surprisingly I haven't seen any huge shifts in U.S. markets sector rotation (except the financials and real estate sectors have been gaining relative strength).

As I mentioned a couple weeks ago, I think we are near a short/intermediate term bottom, however I do not believe the bear market is over. A rally from here would not be surprising.

Strategy 3 allocation is now getting interesting. There are only 2 asset classes above their 200 day moving average resulting in a 3-way allocation between cash, precious metals, and agriculture.

Week of 1-13-2008

Timing Model = -1.0

30% long, 70% cash

10 day moving average: 9% long, 91% cash

Global allocation of long positions

MSCI EAFE Index 30%

MCCI Emerging Markets Index 30%

Russell 3000 Index - U.S. 40%

Top U.S. Sectors

U.S. Oil & Gas 5.5

U.S. Health Care 5.5

Precious Metals 4.5

U.S. Oil Equipment, Services & Distribution 4.0

U.S. Basic Materials 4.0

U.S. Utilities 4.0

Top Intl. ETFs

MSCI Brazil Index Fund 3

MSCI Malaysia Index Fund 3

MSCI Hong Kong Index Fund 2

S&P Latin America 40 Index Fund 2

MSCI Emerging Markets Index Fund 2

Strategy 3

Emerging Markets 20.0%

Money Market 20.0%

Industrial Materials 20.0%

Agriculture 20.0%

Precious Metals 20.0%

EAFE 0.0%

U.S. Large Cap 0.0%

U.S. Small Cap 0.0%

U.S. Long Bonds 0.0%

U.S. REITs 0.0%

Given the state of the sentiment indicators I follow, I believe we are very close to some sort of bottom (short or intermediate term). My model has just ticked up to -1.0 and is very close to gaining more points via the sentiment components.

Buy/Sell Confidence Model

The chart above is a screen grab of Jason Goefert's Buy/Sell Confidence Model (aka Smart/Dumb Money Confidence Model) 2001-2006. This is one of the few models that Goefert doesn't disclose his data sources, but my guess is he is using Rydex/Proshares Fund Asset Flows of index funds and/or CBOE Commitment of Traders data for stock index futures.

I added the red and green bands in Photoshop to more easily visualize the model's behavior in relation to the S&P 500. The dark green bands indicate periods where the model was oversold, the dark red bands indicate periods of over-optimism. The lighter bands indicate periods one month after the model reversed course from an extreme level.

This chart is highly instructive of how most sentiment indicators behave.

1. Market indexes can continue to rise/fall after models reach extreme levels
2. Model reversals are a more reliable indicator of a market reversal
3. Sentiment models do not always reach extreme levels at market tops/bottoms. They aren't closed buy/sell timing models in and of themselves.

I use sentiment models/indicators to counter simple trend indicators. If you've ever experimented with technical indicators such as moving averages you'll know trend indicators are always wrong at both peaks and troughs. By balancing trend indicators with sentiment indicators you can create a timing model that is "less wrong" at key turning points. For example, instead of being 100% in cash at a market bottom, your combo model might suggest you only be 70% to 80% in cash.

I'm not looking for perfection here. You can see that although this model is a great tool, it isn't perfect...and it certainly cannot predict market prices. The purpose of a timing model imho is to reduce portfolio volatility, not to deliver outsized gains. If it ends up doing the later, great...consider it icing on the cake.