A Bearishness Indicator Based on What Investor Is Doing

As discussed in [1], history shows us that more times than not the market will go against the majority. In other words, investor sentiment may be used as a contrarian indicator for the overall market.

There are different ways to measure market sentiment. For example, through

• Surveys of individual and professional investors
• AAII Sentiment Survey
• US Advisors' Sentiment Report
• S&P 500 Put Call Ratio
• CNN Money’s Fear & Greed Index

In this article, we will examine another bearishness indicator based on what investors are doing, not what their opinions are.

Cumulative Cash Flow Ratio

By measuring the ratio of

• Cumulative Cash Flow of "Bear + MM" and
• Cumulative Cash Flow of "Bull+Bear+Sector+MM"

we can calculate the bearish sentiment based on fund allocation (i.e., Bear / Total). The higher the ratio is, the more bearish sentiment is. Be noted that sentiment models don't work all the time and they are weak at pinpointing the exact date of a market bottom.

For comparing with S&P 500 (in solid black line), we have inverted the ratio (in dashed line) to be:

!CCFLALLEX:!CCFBEARM

in the chart (click the image to enlarge). We have also superimposed the "trend following indicator" Parbolic SAR on the ratio.

Interpretation of Parbolic SAR

SAR follows price and can be considered a trend following indicator. Once a downtrend reverses and starts up, SAR follows prices like a trailing stop. The stop continuously rises as long as the uptrend remains in place. In other words, SAR never decreases in an uptrend and continuously protects profits as prices advance. The indicator acts as a guard against the propensity to lower a stop-loss. Once price stops rising and reverses below SAR, a downtrend starts and SAR is above the price. SAR follows prices lower like a trailing stop. The stop continuously falls as long as the downtrend extends. Because SAR never rises in a downtrend, it continuously protects profits on short positions.

Conclusion

As discussed in [3], the primary trend of US stock market is down. However, currently we are in a counter-trend rally. From the high ratio of !CCFBEARM:!CCFLALLEX, the sentiment trend is becoming more and more bearish (i.e., moving lower in the chart above). Be vigilant, enjoy the rally while it lasts!

References

1. Investor Sentiment as a Contrarian Indicator by Wayne A. Thorp, CFA
2. Parabolic SAR
3. A Counter-Trend Rally? Knowing Your Risks