Negative Sentiment Indicates Possible Market Bottom

One major reason I think the market is tracing out a major bottoming pattern is sentiment–specifically, the ridiculously poor sentiment of the last few weeks leads me to believe the market’s next big move is up.

Huh? If you’re not a student of the market, the above statement seems totally wrong. If everyone’s pessimistic, the market will have a hard time moving up, right? Wrong.

Sentiment is used as a contrary indicator–when the vast majority of investors (not just some, but a vast majority) are enthusiastic, it means most of them have already bought shares … and thus, there aren’t enough big buyers left to drive prices higher. Conversely, when everyone’s talking about recessions, depressions and crash-type scenarios, they’ve usually already sold their stocks. So there’s not enough selling pressure to drive prices lower.

Of course, in the long run, the market is going to follow fundamental factors such as earnings, sales, inflation and interest rates. But in the intermediate-term (one to four months into the future), sentiment has a powerful effect on the market.

That’s all well and good, but how do you measure sentiment? Admittedly, it’s tough. If you want hard-and-fast numbers, you can use things such as the percent of newsletters that are bullish (it recently hit a 10-year low) and put-call ratios. But we’ve found that many anecdotal sentiment-related measures are just as useful at spotting turning points … if you know where to look.

Magazine Covers Indicate Sentiment

The obvious example in the anecdotal camp is the neighbor/cab driver/shoe shiner who brags about all the money he’s making in the market. I vividly remember, for instance, a local repairman in our office during early 2000; he stood in front of our board (which lists all our recommended stocks) and was giving us his opinions on them all, as well as suggestions as to what he was buying and selling. Nothing against repairmen, but that’s like us talking about our opinion on the latest engineering designs and specification–when novices are bragging, you’re usually late in the ballgame.

Interestingly, one of the best ways to get a read on public sentiment is by scanning magazine covers. (Cosmopolitan or GQ doesn’t count.) BusinessWeek, Fortune, Time and The Economist are notorious for writing about yesterday’s news–i.e., reporting dramatic events that have already taken place. Oftentimes, negative cover stories come right at market turning points.

Recently, we’ve seen a slew of negative covers. The Economist’s cover from March 22 simply said “Wall Street: A ten-page special report on the crisis.” There was a huge crack running down the center of the page, depicting an earthquake for investors.

But BusinessWeek has been a multiple offender. Its March 24 issue was titled “Waking Up to the Recession.” A month before, the magazine’s cover blared “Credit on the Edge.” And just this week, there’s a huge red picture of Fed Chairman Ben Bernanke that says “Reluctant Revolutionary – Special Report on the Financial Crisis.”

One piece of anecdotal evidence is meaningless, but when you see all these fearful covers, it’s telling you the public believes the worst is yet to come … which leads me to believe the market is likely forming a bottom around here! There’s more to it than that, but these bearish stories are certainly a help in the contrary world that is the stock market.

FYI, in the months ahead, after a bull market has pushed stocks much higher, it wouldn’t surprise us to see covers like “Comeback Kid: How America skirted disaster and is thriving in the post-credit bubble world.” That will be a hint to lighten up, as most of the investors who are worried today will have finally come on board … putting the sellers back in control.

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With all of that said, I still don’t think it’s time to jump into the market with both feet. Too many investors believe that the market is either going up, or going down. Technically, of course, that’s true. It’s also true that the market spends lots of time setting up for a big move. Said another way, it’s not always a bull market or a bear market; sometimes, stocks are just building a launching pad for a future advance.

The buzzword around our office in recent days has been “transition,” as in “The market is transitioning from a bear market to a bull market.” This goes along with our oft-written slogan that bottoms (or tops) are processes, not events. As much as the mainstream media and myriad market pundits want to tell you that TODAY was a major turning point in the market, the truth is that stocks need time to set up, just like a football team needs practice to perfect its game plan.

Why does the market work this way? Because institutional investors, who create much of the market’s movements, need time to build (or, conversely, sell) their positions. And these people aren’t dummies–they’re not about to oblige us by purchasing all of their shares at once, which would drive prices ridiculously higher. No, they usually buy some shares today, and then take a day off, then buy some more on weakness, and so on. They try to get shares as cheaply as possible, just like the rest of us.

Only when these big fish believe that they’re going to miss the boat will they start buying hand over fist. And that time is not yet here–on Tuesday’s bullish upmove, for instance, volume on the NYSE and Nasdaq still came in 3% and 10% below average, respectively. So the big boys weren’t overly active.

Get Ready for New Leaders

So when might the fireworks begin? My hunch is that the upcoming earnings season will be when the proverbial rubber meets the road for this bottoming process. The market often (not always, but often) begins a big move in a different direction during the month after the quarter ends (January, April, July, October) … which coincides with the heart of earnings season. For instance, the Dow hit a low on January 22, when most earnings results were being released. It also topped in the middle of October and the middle of July of last year.

Thus, I’ll be watching the market’s action even more closely than usual in the weeks ahead. The missing component of a sustainable market rally right now is a lack of leadership-type stocks–those with great growth, huge potential, lots of liquidity (so those big fish can buy in) and strong chart action. But earnings season has a way of changing the playing field, so I’m thinking that many new, still-unknown stocks–many of which are quietly building launching pads right now–will jump to the fore.

Research in Motion (RIMM), a leader of last year’s bull market, kicked off earnings season last night with a terrific report, beating estimates and raising guidance. The stock staged a good, but not great, reaction to the news; RIMM still is building a base, and I’m not recommending it for purchase at this time. But as a potential bellwether for the big-cap tech sector, further strength would be encouraging.

Moral of the story: Spend some extra time in the days ahead monitoring big earnings movers. If a new bull market is beginning, which I think is likely, then a bunch of new leaders should emerge off better-than-expected results.

All the best,

Mike Cintolo

Editors Note: Michael Cintolo is Cabot’s Vice President of Investments and editor of Cabot Market Letter, the company’s flagship Letter. Since the start of 2007–a time when the market has experienced many ups and many downs–Mike’s time-tested stock selection and market timing indicators has helped the Market Letter’s Model Portfolio outperform the S&P 500 and Nasdaq by more than 30%. He does this by concentrating his subscribers on the market’s very best leading stocks (First Solar, Crocs and Intuitive Surgical were three of his winners last year), and by telling subscribers when to sell. (He’s advised being in at least 50% in cash since mid-November of last year.) If you’d like to boost your results, give the Cabot Market Letter a try at this special introductory rate.


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