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Investor Sentiment a Boost to Markets? Not So Fast

Stewart Richardson|Chief Investment Officer, RMG Wealth Management LLP
Monday, 16 Jan 2012 | 10:55 AM ET

We have been hearing numerous bullish commentators point to a pervasive bearish sentiment as good reason to be more optimistic on equity markets. The theory is that if everyone is bearish, they must have sold, leaving no more sellers...only buyers.

Rose | Mueller | Stock4B | Getty Images

Certainly, markets have rallied in the early part of the New Year. The bulls are expecting the bearish camp to capitulate and buy into the equity markets, thereby propelling the market through immediate resistance and markedly higher over the next few weeks.

The fact that the Dow Jones Industrial Average is trading comfortably above its own 200-day moving average will also excite some investors.

But wait a minute. Is this view valid? Is the market as bearish as bullish commentators hope? There is a market law that says that when all the experts agree that something will happen, then something else entirely will occur.

Traders use sentiment indicators to find extremes and then use this information to take positions. Now for example, if it is true that sentiment has become obviously overly bearish, it would be right to consider buying on a continued correction in the market.

But....an index of bullish sentiment as measured by a poll of small traders in the futures market is currently 44 percent bullish, which is hardly an extreme reading and certainly doesn't give a decisive signal as to the market's near term direction. Other similar polls show exactly the same; more an excuse to sit on your hand rather than pull the trigger.

To wrap this discussion up, bullish pundits are arguing that investors are overwhelmingly bearish which is bullish for the market. This does not seem to be the case. Many measures of sentiment among market participants (not the wishful thinking of market commentators) show that sentiment is not at an extreme that would indicate an opportunity to buy.

In fact, these measures must be classified as neutral and indicative of an indecisive market that has already rallied by 20 percent from the lows last Autumn. US and European markets are also approaching price levels that should act as resistance.

It will take concerted buying activity to push these markets upwards through these levels of resistance. So far this year, market participants seem very undecided about the next major move as demonstrated by the low volume of shares traded on the New York Stock Exchange which is even running below the volume seen in the week before Christmas and way below the average of the last few months.

If the bears or the bulls were in charge and the market was in a persistent trend, then the volume to be much higher, especially as market participants are supposed to be back at their desks working.

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The author is.... Stewart Richardson, Chief Investment Officer RMG Wealth Management LLP

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