Stock Market Sentiment: We Can Only Go Higher

To begin the year I provided an analysis in 2012 Outlook: United States Stock Market on why I felt the stock market was overvalued looking at fundamentals such as price to earnings and corporate margin readings.

Today I want to take a look at another factor that is equally important to determining both short and long term price directions: Sentiment.  For an in depth discussion on why sentiment is important you can review 2012 Real Estate Outlook: The Fall (2006 - 2011).

This past week Barron's headlined the market euphoria by gracing its cover with "DOW 15,000."

The article goes on to say that, "even by conservative measures the DOW could top 15,000 within two years.  DOW 17,000 is a 50 - 50 bet."  As a reminder, here is the cover of Barron's back in March of 2009 when the market was touching bottom:

Looking at newsletter writers across the spectrum is an excellent gauge on market psychology.  The chart below shows that the number of newsletter writers turning bullish on the market has surged with the recent stock market move higher.  You will notice on the graph that these writers had an extremely bearish outlook on the future direction of the market at the recent market bottom back in September.

Elliott Wave, one of my favorite newsletters that studies the sentiment readings in the market, put up a graph this week showing a composite of four major sentiment indicators:

-CBOE Put/Call Ratio
- Market Vane's Bullish Consensus
-Investor Intelligence % Bulls
- AAII % Bulls

By combining all four together they saw that the market is at a bullish level only reached twice in the last 5 years.  The first was at the all time DOW peak back in late 2007, and the second was at the end of the QE2 market surge back in late 2010.

Both times the markets were drunk on euphoria and both times the markets soon turned downward.

RBC's sentiment index includes 3 of these 4 indicators plus a few more. The following is the composition of their RBCCM index:

The graph below shows where this index currently stands, moving toward the higher range of the optimistic extreme:

The darling stock today receiving all the headlines is Apple.  It recently rocketed through the 500 mark and moved upward toward the stratosphere touching over 525.  Bloomberg interviewed 57 of the top stock analysts this week regarding the future direction of Apple's price.

56 out of 57 analysts said to buy it today.

Is the DOW going to 15,000?  Maybe. Is Apple going to 800? Maybe.  Every newsletter, stock analyst, and media outlet will tell you that this is coming.  No one asks why all these analysts all wanted to sell stocks when they were 20% lower back in September.

I like to buy things when no one wants them, which means right now I do not want to own stocks.  For those that are more experienced in the market, short term extremely high sentiment provides a strong shorting opportunity in the market, meaning you can make money if stocks move lower.

I'll leave you with a quote from Richard Russell's newsletter this week.  Russell has been writing for over 50 years and is considered the godfather of investment newsletters:

“The worst kind of market is a market that goes down on good news. As I write, optimism is in the air, and the Dow is down 95 points. Dow 10,000 continues to be the great psychological barrier and my work suggests that that Dow 10,000 will be tested in the next few months. Therefore the operative word is caution. Keep the word caution in you conscious unconscious mind.”