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Too Bullish Is A Warning

I agree with most market commentators, analysts and strategists: November's correction is unlikely going to kill off the positive undertone for risk assets, but it does provide investors with an excellent opportunity to pause and see whether there are any conclusions that should be drawn. You know the rap; lessons for the future. If you're not making any money right now, you might as well become a little wiser, so maybe next time you'll find yourself in a better position. The first conclusion that would come to mind is that price action over the last ten days or so has again brought forward the reminder that when everybody seems to be making money from the same trades, the market has a nasty habit of shaking the tree through sudden and sharp corrections, at trigger points unknown. This, in itself, links very well with what has become my favourite market description these past weeks: Don't be shy to join the party and mix with the crowd on the dance floor, but make sure you stay close to the exit. Just exactly how "sudden" this month's correction is remains a matter of debate. FNArena, myself in particular, has pointed out repeatedly over the past years that currencies continue leading other markets, so a strengthening US dollar should have put every trader and investor on high alert this month. I do realise not everyone who reads my analyses has been doing so since day zero, which is why I have lined up a few older stories that provide background, explanations and past references for those who want to know why they should pay close attention to the US dollar, even if they're not necessarily playing the negative correlation via gold or other precious metals (see bottom of today's story). Also, FNArena has recently added a few market trading-technical analysis oriented educational videos from Advanced Trading Workshop (ATW) to its Investor Education section on the website. These videos (and their related stories in our news section) have been pretty popular. The fact they warned about a pending come-back for the greenback might be a logical explanation for this. There has been one other warning signal flashing in the background since late October, one I haven't mentioned before: excessive optimism among US investors. The American Association of Individual Investors (AAII) regularly releases the results of sentiment surveys amongst its members. These results are being closely followed by many experts and strategists on Wall Street, not in the least because history shows these AAII surveys seem to function as the ultimate, reliable contrarian indicator. At the end of October the number of bulls in the survey had once again risen to bubbly highs - a level not seen since February 2007- which raised two obvious questions: how much of this was QE2 inspired and would this again prove to be a warning signal? I think the events since the Fed's QE2 announcement have now provided us with the key answer we were looking for: even with QE2 supporting the US share market, when investor sentiment runs too positive, a correction shall follow. The good thing about these surveys is that AAII releases the results on its website, so everyone can keep track via Don't pay too much attention to long term averages and all that, what matters is that when these surveys run into extremes -bullish or bearish- they tend to act as a contrarian signal. Thus... when bears rule it's time to start buying, but when the bulls rule it's time to dance near the exit. In recent times, the AAII survey reached a bearish low at the beginning of July, which would have been a near perfect entry point to catch thesubsequent rally, while the bullish extreme at the end of October should have put everyone on high alert. BTIG market strategist Mike O'Rourke is a self-confessed close follower and analyst of these surveys. According to his guidelines, one should take the three categories Bulls-neutral-Bears, remove the middle group and re-calculate the balance between Bulls and Bears. As such, the Bulls still rule with a little below 67% in numbers, which is down from more than 70% 2.5 weeks ago, but still too high for comfort. O'Rourke has observed in the past that when the overall economic picture is improving, share markets can continue rallying even with Bullish readings in the AAII surveys at extreme highs. This is what happened in 2003. This is why I am curious whether the Fed's QE2 could possibly initiate another period of exception, especially if we would see better economic data in the months ahead. For now, however, it would seem that extreme levels of optimism should still be taken as a major warning signal. Note that in January this year, when share markets peaked for the first time since March 2009, the number of Bulls had risen to just under 70% (not long after markets retreated). I don't have any numbers available for April, but I would suspect a similar picture. O'Rourke always warns these surveys should never be taken at face value. One has to apply some logic and some judgement. For example, after a big market correction, sentiment tends to rise. This is then not a signal that another sell-off is forthcoming, of course. Equally important is the fact that extreme readings from these surveys have proved a very reliable contra-indicator over 6 months periods, or even longer. This, however, would be a negative this time around given the extreme reading at the end of October. So for those who bear a dim outlook for the share market in months ahead, the AAII survey would have provided more evidence to remain cautious. All others will be hoping that QE2 simply supercedes everything else. Here's one personal observation from the two weeks past: it seems more and experts have given up on the S&P/ASX200 reaching 5000 this calendar year. Apart from predictions about a "sideways moving market into the new year", year-end targets are being pulled back. For what it's worth: I don't think the market will manage 5000 either. Below are the calculations O'Rourke published in January this year. They clearly show that when sentiment in these AAII surveys runs into extremes, market performances are usually not that fantastic in the weeks, even months ahead. It's when sentiment sinks to very low levels when ideal entry points present themselves. The problem now is, of course, such entry levels seem far off in the current context. The good news is, 70% is still significantly lower than the 85% and higher seen at certain points in the past, and they all proved strong sell signals. Maybe what this market needs is a prolonged consolidation, to get rid of the excessive optimism, in order to create a more sustainable platform for the next leg upwards? By Rudi Filapek-Vandyck, Editor FNArena