Is the end of the rally that has lifted the markets for the last 5 months? Or is it the just the end of the world as we know it?

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The "Mixed Signals" [11] from 2 weeks ago, which morphed into last week's clues [12], must mean something this week as the markets had their worse day in 7 months on Friday. Oh my goodness, did you read that right? I don't think it means the end of the world as we know it but it might mean the end of the rally. But is it really this bad? If you bought the SP500 around Christmas time or anytime in the new year, your position is underwater just by a little. On the other hand, if you were dumb enough to believe the hype that the "all clear" signal had been sounded, then you deserve to be underwater and have a loss. For that matter, you shouldn't be playing in the markets at all.

When I get a call from my mother 6 weeks ago about what she should do with the gold fund that had been left to her by my deceased father (and her husband) and if now would be a good time to put it in the stock market, then I know we have a top brewing. (Editor's note: we kept the gold fund.) Furthermore and as an aside, what is my 80 year old mother doing putting money in the stock market? When I get another call yesterday about the market "tanking", then I know I shouldn't worry too much. Yes, my mother used the word "tanking". "Tanking" could be used (but not really) in the context if you got into the markets 6 weeks ago, and it certainly cannot be used after the 30% run of last year. But let's be clear. I know my mother isn't doing her own investing, but I am sure the raging bull market must be the talk of all the retirees at the country club.

I doubt the world will end as we know it (but it could happen), but it is more likely the rally will continue to struggle. This is another way of saying what I have been saying for the last 6 weeks: we are late in the rally and the trend should flatten out. Now we can add underwater investors to the mix. These are the investors who were late to the rally and are now saying to themselves, "Geez, I shouldn't have bought XYZ stock when Cramer told me so." Now these folks are worried (because they don't have a plan), and they will be sellers into any rally. They can't tolerate even a small loss; they have learned their lesson that the markets are hazardous to their financial health. They want out and will be sellers especially into a rally that trims their losses. This puts a cap to the upside.

This market narrative, whatever it may be, is only starting to play out. There will be both bullish and bearish talk. I saw a bull headline today: "S.KOREA TO HOLD EMERGENCY MEETING ON JAN. 26 TO DISCUSS MARKETS". The investing mindset remains such that investors belief in the Federal Reserve or other central banks has yet to be shattered. I think that moment is a long ways off, and will coincide with a technical failure in the markets. So what do I mean by this? The markets will sell off at some point in the future and investor sentiment will turn bearish. We will become buyers when everyone else is bearish. The markets will lift like they do 80% of the time under such dynamics, and there might even be an announcement by the Fed that supports the markets and investors beliefs that the Fed has their back. But for whatever reason, the bounce will fail and the markets will move (crash?) lower not only violating those important technical levels that brought in the buyers in the first place but also destroy the notion that the Fed has control. That's how I see a top in the markets.

For now and the best that I can say is this: after a 5 month bull run, the bears have finally awoke from their slumber, but this is all they have done. Our equity model, which is based upon the "dumb money" indicator in figure 2 (below), remains bullish. A bear signal will register 1 week after investor sentiment rolls over. This has not happened yet.

Lastly and let me be clear about what I do. I don't need to make forecasts to profit from the markets. I am very cognizant of where we are on the playing field. We are late in the rally, and valuations, which are a poor timing tool, would suggest that we are late in this cyclical bear. (You should note I said "cyclical" not "secular" bear.) But this has little to do with getting in and out of the markets profitably and with limiting your risk. We have been bullish for 20 weeks now when we became bullish during a period of extreme investor bearishness. The current trade is "long in the tooth" as the average trade goes on for 15 weeks. I have been saying this for weeks: "We are in the late stages of the rally. The best, most accelerated gains typically occur in the beginning of the trade. Just when investors typically get the all clear, the trend will flatten out." So why not get out now? Because that is not how I do it, and you just never know. Our exit is the "best" exit of the many types of exits we have tested. As a reminder, we have moved our stop loss up to SP500 1706.92.

The Sentimeter

Figure 1 is our composite sentiment indicator. This is the data behind the “Sentimeter". This is our most comprehensive equity market sentiment indicator, and it is constructed from 10 different variables that assess investor sentiment and behavior. It utilizes opinion data (i.e., Investors Intelligence) as well as asset data and money flows (i.e., Rydex and insider buying). The indicator goes back to 2004. (Editor’s note: Subscribers to the TacticalBeta Gold Service have this data available for download.) This composite sentiment indicator moved to its most extreme position 10 weeks ago, and prior extremes since the 2009 are noted with the pink vertical bars. The March, 2010, February, 2011, and February, 2012 signals were spot on — warning of a market top. The November, 2010 and December, 2012 signals were failures in the sense that prices continued significantly higher. The current reading is neutral but heading towards bearish (as in too many bullish investors).

Figure 1. The Sentimeter

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Dumb Money/ Smart Money

The “Dumb Money” indicator (see figure 2) looks for extremes in the data from 4 different groups of investors who historically have been wrong on the market: 1) Investors Intelligence; 2) MarketVane; 3) American Association of Individual Investors; and 4) the put call ratio. The indicator shows that investors are extremely bullish.

Figure 2. The "Dumb Money"

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Figure 3 is a weekly chart of the SP500 with the InsiderScore “entire market” value in the lower panel. From the InsiderScore weekly report: “Market-wide sentiment continues to move further into Neutral territory, away from a Sell Bias, as transactional volume continues a seasonal decline. With earnings season beginning shortly, most companies have closed trading windows, limiting the ability of insiders to transact non-10b5-1 purchases and sales."

Figure 3. InsiderScore “Entire Market” value/ weekly

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