Focusing in on Oscillators

Bottom Line: We are seeing a very high number of uncertain responses to some of the sentiment surveys. History suggests that the market is more likely to oscillate back and forth than trend strongly after such periods.

Feeling unsure about where the market’s going? You’re certainly not alone. In April, I discussed readings from the lowrisk.com and Investor’s Intelligence sentiment surveys that showed a very high number of neutral responses. The case can be made that once again, we are seeing an unusually high level of uncertainty.

The American Association of Individual Investors (AAII) came out with their most recent survey results today showing 33% bulls (down from 36% last week) and 27% bears (down from 40% last week). The rest of the respondents didn’t have an opinion one way or the other, and at 40% of the total this contingent of fence-sitters was the highest in over a year. Looking at the Investor’s Intelligence survey, it too continues to show an unusually high number of uncertain responses. Over the past twelve weeks, an average of close to 30% of the population was neutral – the greatest amount since 1992. Technically, “neutral” according to I.I. isn’t really neutral, it is bullish but expecting a short-term pullback. But to me, someone who says they are bullish, but expects prices to decline, is neutral.

Back in April, I noted that my feeling was that an extraordinarily high number of neutral respondents would lead to a choppy market over the next several months, one that had difficulty sustaining a meaningful trend. If true, it could have a profound influence of what types of strategies are most effective for traders – one that tries to capture trends (like breakout strategies) or one that tries to play a range-bound market (like overbought/oversold indicators). Today I went back and looked at the entire history of the I.I. survey, and the results do support the likelihood that a range-bound market is ahead of us.

To test this, what I looked at was the 12-week moving average of neutral responses in the survey from 1969 through the present. I then sorted the readings from highest to lowest and looked at the top and bottom 5%. This narrows down the survey readings to those times when we saw the most uncertainty (in terms of many neutral responses) and those times we saw the least uncertainty. Note that those times with the least uncertainty are not necessarily those times the respondents were most bullish – it could be they were very bullish or very bearish, but they were expressing a strong opinion one way or the other.

Next, I looked at how the S&P performed over the ensuing six months. I wasn’t necessarily interested in whether it tended to go up or down, I just wanted to see how much it moved. To see, I looked at the maximum gain the S&P enjoyed over the next six months, and also the maximum loss it suffered. Looking at the difference between the two gives us an idea of how volatile the index was over the next six months. The table below shows these results.

	Lots of Strong Opinions	Lots of Fence-Sitters	Random
Average	19%	11%	15%
Max	39%	22%	41%
Min	9%	5%	4%
St. Dev.	7%	5%	7%

We can see that the average volatility after periods when respondents had strong opinions was 19%. This means that the difference between the maximum price over the next six months and the lowest price was 19%. We saw as much as a 39% difference, but nothing lower than 9%. The standard deviation was 7%.

After periods, like now, when the number of neutral responses was very high (i.e. lots of fence-sitters), the average difference between maximum gain and maximum loss dropped to only 11%. The largest was 22% and the smallest was 5%. These results are significantly different from the other periods – in fact, they were nearly ½ as volatile as the opposite extreme.

These results suggest that the tug-of-war between those who are trying to form an opinion will most likely lead to something of a choppy market that is prone to reversals, and not one that is likely to see a strong breakout to the upside or downside. Just as enough of a trend is formed to bring a majority of players on board, it will reverse. I believe in these times that using overbought/oversold types of gauges, such as our sentiment measures, or common technical indicators such as stochastics, will prove more effective than trying to chase nascent trends.

Last time, I noted the excessive enthusiasm we were seeing from bullish Rydex traders, and how it was symptomatic of a renewed sense that our troubles were behind us, a scant two weeks after a veritable cornucopia of concerns. That lead me to believe that significant upside progress in the short-term was unlikely, so the action we’ve seen since then seems appropriate.

The choppiness this week has served to wear off some of the extreme overbought readings we saw in our short-term measures entering the week, and now some of the longer-term ones are wearing off their respective overbought readings. Tomorrow’s jobs report is once again garnering the attention of nearly everyone. Looking back on my notes, the report seems to have taken on extra importance beginning in February of this year (at least according to what traders were saying), and each of the reports since then has indeed triggered outsized moves. Our short-term measures are pretty much neutral across the board, and I would not fight the initial trend from the report. The market has tended to maintain a short-term trend in the days after recent reports, and I don’t see anything in our measures that would suggest that fighting the short-term move is a good idea.

This disclosure is not intended as trading advice in any form. It is meant as a note to subscribers that the author may have a position directly affected by the market outlook reflected in the commentary. Although the author takes great pains to remain objective in any commentaries, it is only fair that readers should know that the author may have taken positions in accordance with his market outlook. Positions can and do change at any time, without notice to the reader.