What History And Sentiment Can Tell Us About The Recent Market Volatility

If it feels like the market has been moving sharply recently, then you’re not alone. But how much of this is just media hype, and how much of it lies in reality?

Since the beginning of May, traders have suffered through three sharp pullbacks. The most recent was a three-day decline of 3.6% from high to low. There was a 2.5% three-day pullback in June and a 4.5% three-day pullback in May.

The truth is these were relatively small moves. It wasn’t very long ago that a 5% pullback was expected to occur an average of two or three times a year. But that was when there was less media coverage of the stock market and less public participation.

Now, there are many new investors who believe moves like this are unusual. We know that because of what we’ve seen in the sentiment data over the past month.

Among the most useful sentiment indicators is the weekly survey of the American Association of Individual Investors, or AAII. Every week since 1987, AAII conducts a survey that asks participants the same question — are you bullish, bearish, or neutral about the next six months?

This week, the data shows the effect volatility is having on individual investors.

Source: AAII

What We Can Learn From This

The number of bulls, bears, and investors who are neutral doesn’t show exuberance or fear. The most interesting aspect of the data is the fact that the number of bulls fell by 18% in four weeks.

Rapid changes in the percentage of bulls shows anxiety is high. One week, investors have a fear of missing out on additional gains. The next week, they have a fear of falling prices. This anxiety is likely caused by the recent market action and is likely to continue.

I reviewed the historical data to see how unusual a move like this is. I found that this is in the highest 3% of shifts among the bulls. This is the 57th biggest drop in the percentage of bulls in the 1,774 weeks of data. That’s enough data to consider what happened in the past after these types of shifts.

Since 1987, after drops like this, the S&P 500 dropped an average of 0.87% in the next four weeks. That’s bearish considering that this compares to an average four-week gain of 0.33% over the entire period.

The S&P 500 declined 52% of the time after an extreme decline in the percentage of bulls. Initially, that might not seem like much of an edge since many investors believe short-term price moves are basically a coin flip with a 50% probability of being up or down.

But short-term price moves aren’t really a coin flip. Since 1987, the S&P 500 delivered a gain 64% of the time in a four-week period. That’s quite a bit different than the 48% of the time stocks went up after this sentiment shift.

Closing Thoughts

This is a reason to be slightly bearish. My Income Trader Volatility (ITV) indicator confirms that outlook, as shown in the chart of the SPDR S&P 500 ETF (NYSE: SPY) below.

ITV is similar to VIX in that it rises as prices fall. Its current position, with the indicator (red) moving above its moving average (blue), points to potential weakness in stocks.

Our last chart this week shows my Profit Amplifier Momentum (PAM) indicator, which is also bearish.

PAM is designed as a short-term indicator. Its bearish crossover is a potential indicator of weakness. Downward momentum seems to be strong.

A down move remains likely in the short term. And that’s why I’m relying on a simple trading technique that’s specifically designed to deliver short-term payouts, regardless of the overall trend in the market.

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