The Art of Sentiment

I am a strong proponent of using sentiment as a trading tool. The theory behind using sentiment as a trading tool can be summarized as follows: When the crowd is extremely bearish it is likely they have already sold, leaving fewer sellers and creating a low risk buying opportunity. The opposite occurs when the crowd is extremely bullish. Its likely they have already bought and there are few buyers to propel the market higher.

Right now a few of the sentiment indicators I look at are showing bullishness being on the high side. However, most evidence points to large investors being positioned very conservatively. The Merrill Lynch Fund Manager survey as well as the ISI Hedge Fund surveys show equity exposures being  on the low side. Anecdotally, it seems few in the hedge fund world are very bullish.

In essence sentiment indicators are a tool to help figure out how the crowd is positioned. Looking at all the evidence it seems that large investors are still positioned conservatively albeit less conservatively than they were a few months ago. Shorter term traders seem to be more bullish. This leads me to believe that there is risk of a pullback but the risk of a large drop is low, barring a systemic event.

Many are pointing to the sentiment indicators as proof of a coming collapse. A year ago sentiment indicators became far more extreme than they are now and stayed that way for a long period of time. The reason that was able to occur was that investors "derisked" in the  Summer of 2010 and decided to "rerisk". If large investors decide to "rerisk" again this year we could see a repeat.

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