Sentiment Indicators Scream Buy

I'm having a bit of trouble right now. Two of my favorite sentiment indicators, the ISE Sentiment Index, or ISEE, and the Smart Money Index indicator published by SentimenTrader.com, are at levels that signal very high-probability buying opportunities. My challenge is in simply following the signals without overthinking.

The ISEE measures opening purchases of call and put options by retail traders.

The resulting put/call ratio has been pretty good at signaling significant turns because of its focus on the retail segment.

The theory is that when retail traders reach extremes in sentiment, the market is poised to prove them wrong.

If you compare the extremes of the 50-day moving average of the ISEE on the chart below to the corresponding dates of the S&P 500, you'll see that they correlate quite nicely

The ISEE low in late 2004 corresponded with a sustainable bottom, and about a third of the way through 2005, we saw a low in the ISEE 50-day moving average and a low in the S&P 500.

So given the current low in the ISEE, I believe the rally of the past few sessions could have some legs.

I'm not concerned about whether the S&P 500 could establish a sustainable high right now. I'll deal with that when I see a credible challenge.

ISEE Level Indicative of Further Rallying?

Source: International Securities Exchange

The Smart Money Index is constructed from the movement of the S&P 500 during the first 30 minutes of trading and the last 30 minutes. The underlying theory is that the emotional amateurs (the dumb money) control the open and the well-reasoned professionals (the smart money) control the close.

This indicator has a very good track record when the two camps are at extremes. I've highlighted the three times over the past couple of years when the amateurs have been heavily selling at the open and the professionals have been heavily buying at the close. You can see the first two times have had a nice correlation with a low in the S&P 500. The current extreme readings in the SMI accompany the breathtaking decline of the past few weeks. So according to the SMI, it's time to buy.

Smart Money Index Giving the Buy Sign

Source: SentimenTrader.com

Can you see how the ISEE and SMI are both flashing buy signals that have proven reliable over a period of months? I don't consider either of these indicators to be short-term timing indicators. I view them as a signal to start putting money to work with some degree of confidence that you'll be pleased with the outcome a few months down the road.

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Fitzpatrick is a freelance writer and trading consultant who trades for his own account in Encinitas, Calif. He is a former co-manager of a hedge fund and teaches seminars on technical analysis, options trading and asset-protection strategies for traders and business owners. Fitzpatrick graduated from the McGeorge School of Law and was a fellow at the Pacific Legal Foundation, a nonprofit public interest firm specializing in constitutional law. He also practiced law in the private sector before pursuing trading as a full-time career. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Fitzpatrick cannot provide investment advice or recommendations, he appreciates your feedback; click here to send him an email.