Systematic Relative Strength

And that’s a good thing. Investor sentiment works very nicely when it is interpreted in a contrary fashion. In other words, when everyone is bearish, prices tend to go higher. One of the long-time sentiment gauges for the domestic stock market is the Advisory Sentiment Index compiled by Investors Intelligence. This indicator was originally developed by A.W. Cohen, the popularizer of the 3-box point & figure reversal chart. Bloomberg reported the most recent levels today and advisors are decidedly negative.

The following are results from Investors Intelligence’s analysis of investment newsletters for July 7 through yesterday.

             This Week  Last Week  Comments
Bullish *      32.6%      37.0%    Lowest level since March 2009
Bearish #      34.8%      34.8%    Stays at highest in 12 months
Correction &   32.6%      28.2%    Biggest jump since January
     * The bullish reading fell to 22.2 percent in October 2008,
the lowest since November 1988.
     # The bearish reading fell to 15.6 percent in December
2009, the lowest since April 1987. It rose to 54.4 percent in
October 2008, the highest since December 1994.
     & The correction reading rose to 39.8 percent in February
2010, the highest since September 1983.

Since I like to stick to actual evidence and testing, I referred to Robert Colby’s Encyclopedia of Technical Market Indicators (Colby & Meyers, 1988). After examining 17 years of advisory sentiment data, they conclude:

When a relatively small percentage (37.5% or less) of advisory services were bullish, there was a significant bullish tendency for stock prices.

The 37.5% threshold applies to a 4-week average of the bullish readings-the current 4-week average is 38.0%. There was also a very bullish tendency for single week readings below 32.7% bulls, which is where we find ourselves this week. Because Colby and Meyers tested everything for statistical significance, “very bullish” readings are defined as:

Probability less than 1 in 1000 that the stock market rose by random chance alone after an indicator reading in this range of values for the specified time frame. Therefore, we can be 99.9% confident that the indicator is significant.

It’s important to note that the significance of the Advisory Sentiment Index was only apparent at the 6-month and12-month time horizons for the 4-week average and at the 12-month time horizon for the single week reading. At 1-month and 3-month time horizons, statistical significance was not achieved. In other words, stock prices are likely to be higher 12 months from now. The likely path to higher prices could be smooth or rocky from here, but nothing is certain over the near-term time frame.

To put a bow on it is an article that appeared on Doug Short’s website. He points out that often high-yield bonds lead the stock market. High yield bonds are showing a positive divergence right now.

Source: dshort/Kimble Charting Solutions (click to enlarge)

It’s interesting to note that some of the preconditions for a stock market rally are starting to appear at a time when the public is very negative on stocks. I guess it’s always darkest before the dawn. Economic data aside, stock market data is arguing that things might not be so bad.