Why Investor Sentiment Tells Me A Market Rally Could Happen Soon…

Gaps are now the most important feature on the chart of the SPDR S&P 500 ETF (NYSE: SPY).

Gaps are areas on a chart where the price makes a large move between the close and the open. In SPY, there was a gap lower on Monday, September 20. That’s highlighted by the blue arrow in the chart below.

The low of the gap day is marked by the blue line. SPY seems to have found support at that low. That low also coincides with a price target derived from the topping pattern highlighted by the gold lines. This pattern started with a gap up and ended with a gap down.

Psychologically, that topping pattern could have been tied to a burst of optimism after the Senate passed a bipartisan infrastructure bill, and it looked like Congress could work together. Or it could have been driven by hope that the FDA’s formal approval of the Covid vaccine would lead to a reduction in cases. Neither of those events followed a best-case scenario, and the selling could have been driven by the reality that Congress is dysfunctional and Covid is a long-term problem.

The chart tells us that we are back to where we were in August, when traders were optimistic and pushing SPY to a new all-time high. However, individual investors are not as optimistic as they were then.

The percentage of bulls among individual investors fell sharply last week, according to the American Association of Individual Investors survey.

Source: AAII

As I’ve noted the past few weeks, the high percentage of bears following such a relatively small decline in the indexes shows how nervous individuals are. The high number of investors who are neutral is relatively bullish. These are investors who want to be pushed firmly into the bullish or bearish camp.

The fact they are neutral instead of bearish indicates that it’s likely they already reduced positions as much as they’d like to in the current environment. They are most likely sitting on cash looking for an entry level. If they turn bullish, they will be buyers, and that could push prices up.

The chart of SPY above shows that the price action could push them into the bullish camp. The recent rally ran into resistance at the low of the day before the gap. We can expect a rally when the gap is filled, so a break above this resistance level would indicate to technical traders that the decline has ended.

What I’m Watching Now…

Small-cap stocks — the most speculative sector of the market and the group that should lead in a bull market — are also near a bullish breakout, as the chart of iShares Russell 2000 Index Fund (NYSE: IWM) shows.

IWM remains near its 50-day moving average and ended last week above its MA. The orange lines show a narrowing range, and a breakout should be followed by a sharp move. I continue to expect an upside breakout in IWM.

In the short term, I’m relying on my indicators, which are increasingly bullish. My Income Volatility indicator (ITV) remained bearish for SPY but remains at a high level that’s consistent with short-term bottoms. It is leveling off, and I expect to see a decline in the value of the indicator by the end of the week. That would point toward an upcoming rally.

My Profit Amplifier Momentum (PAM) continues to support my bullish thesis. This indicator already reached its bearish extreme and continues moving back toward a “buy” signal. As long as prices hold above last Wednesday’s high near $435, we should see a “buy” signal in SPY on Monday or Tuesday.

Action To Take

PAM is designed as a short-term indicator. It shows a breakout is likely this week.

Based on my indicators, I’m still bullish for the short term. But to mitigate risk, I’m looking for pockets of value in this market. Specifically, I’m looking for solid stocks that have sold off and show strength — or beaten-down stocks that didn’t fully enjoy the major rally we’ve seen up until now. And to further reduce risk (while still enjoying upside), I’m using a simple strategy to reduce may cost basis and earn more income…

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