The One Reason Behind the Powerful October Rally

Being in the investment business, I am often asked why the market is going up or down.

These days, my answer is usually something along the lines of specific news from Europe or an economic report that came in better or worse than expected.

In reality, the ONLY reason a stock or the market goes up is that there are more buyers than sellers and the reason it goes down is because there are more sellers than buyers. The reason behind the move may be based on some sort of news, but the news itself leads to buying or selling.

We sometimes forget this very basic premise and it doesn't matter whether you are seasoned investor or a novice investor. We get so caught up watching certain indicators and certain news, but the fact remains that the market goes up when there are more buyers than sellers.

What happened in October was that there were far more buyers than sellers. Was the news so great that the S&P 500 should have turned in its eighth best monthly percentage gain over the last 60 years? Probably not.

Were the technical indicators so bullish that we should have seen the S&P 500 rise by 10.8 percent? Not really.

Were the earnings reports so impressive that we should have had the second biggest monthly point move in the history of the S&P 500? I don't think so.

So why did we see the big rally? Because investor sentiment was more bearish than it should have been leading into the beginning of October.

Sentiment tells us when the probability of having more buyers than sellers is highest. It also can create strong rallies on mediocre news. Look at it this way: If everyone owns a stock and everyone is bullish on a stock, who's left to buy the stock? If everyone that wants out of the market has already gotten out during a correction, the only people left are buyers.

When the sentiment towards the market reaches a bullish or bearish extreme, the probability is now on your side to play the market the other way. In other words, you want to view sentiment analysis from a contrarian viewpoint. Some of the best investors in the world are contrarian investors including Warren Buffet and George Soros.

You have probably heard the expression "the best time to buy is when there is blood in the streets." This statement is at the heart of contrarian investing.

Two Sentiment Indicators I Watch

Let's look at some of the sentiment indicators for the overall market and where they were before the rally. By doing so, I hope to help you understand how you can use sentiment indicators to better time your investments in the future.

The Investors Intelligence Report surveys the sentiment of more than 100 investment newsletter editors. It is a survey measuring the number of my colleagues in the newsletter industry that are bullish or bearish.

The Investors Intelligence Report is released every Wednesday and it is expressed in terms of the difference between bullish advisors and bearish advisors on a percentage basis. I like to look at the bullish and bearish percentages in a ratio as this eliminates the neutral camp.

The Investors Intelligence Report released on October 5 showed 34.4 percent were bullish and 45.2 percent were bearish. Dividing the bullish percentage by the bearish percentage we get a reading of 0.76. This was the lowest reading since August 2010 and only the second reading below 0.80 since the bear market ended in the spring of 2009.

If you look back at the six-month performance of the S&P 500 after the extremely bearish reading at the end of August 2010, you see that the index rallied almost 25 percent. Flash forward to October 2011 and you'll see that the Investors Intelligence ratio dips below 0.80 again and then we see the S&P turn in the eighth best monthly percentage gain in the history of the index going back to 1950.

Another sentiment indicator I like to watch is the Rydex Nova/Ursa Ratio. The Rydex family of funds has the Nova Fund which is a bullish fund and targets a return that is 150% of the return of the S&P 500. The Ursa fund is a bearish fund and targets a negative 100% correlation of the S&P 500. The ratio is simply the assets of the Nova fund divided by the assets on the Ursa fund. The higher the ratio, the more bullish investors are and the lower the ratio, investors are more pessimistic.

The readings on the Nova/Ursa Ratio at the end of September and beginning of October were down under the 0.20 level which are the lowest readings in a long time. In August 2010, the ratio was down to the 0.25 level just before the market took off on a six-month rally.

The sentiment indicators can be viewed as a pressure gauge for the market. When the sentiment is too bullish, the pressure is likely to come from the selling side. When the sentiment is too bearish, the pressure is most likely to come from the buying side. When investors see extreme levels of pessimism, we get rip-your-face-off rallies like what we saw in October.

The sentiment has started to move away from the overly pessimistic levels we were seeing, but it is far from hitting optimistic levels. I'm expecting the bearish sentiment to continue to unwind throughout the next few months, and this should lead to stocks moving higher at least through the end of the year.

Rick Pendergraft
Editor, ETF Master Portfolio

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