Sentiment Backdrop Is in the Right Place

We made the case Friday for this market possibly reaching a "good" low. One aspect of a good low being made is sentiment.

Sentiment is important in determining if the market is close to a bottom, but sentiment indicators are often misread or ignored when it matters most. This is understandable considering the emotional state traders have to reach in the process of creating extreme sentiment readings.

When traders are worried about the Bear Stearns (BSC - commentary - Cramer's Take) collapse taking down the entire financial system, and they're in the process of panicking, they're typically not paying much attention to indicators of any sort.

Sentiment has currently reached extreme levels across our series of indicators. This doesn't mean that it couldn't get more bearish, but it does suggest that we have the sentiment backdrop in place for a meaningful reversal.

We break sentiment indicators down by two types. The first are surveys where traders are asked if they are bullish or bearish. In our opinion, these are unreliable most of the time. Since there is often a difference between what people say and what they do, we only pay attention to these surveys when extreme readings are registered.

Investor Intelligence

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Currently, we are seeing sharp increases in the number of traders providing bearish responses to these surveys. The Investor Intelligence survey percentage of bears reached 43% last week. This is the highest reading since the bear market lows in 2002 and the 1998 "Asian contagion."

AAII Survey

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The AAII survey also shows the highest number of bears since 1990. This shows some very bearish sentiment in this market.

VIX

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The second type of sentiment indicators are quantitative measures of fear. The VIX is an example of this type of indicator that most traders would be familiar with. The VIX has recently moved out beyond two standard deviations of a 21-day moving average of the highs. This is a signal that shows relative extremes. Relative extremes in the VIX are more important than absolute levels in the indicator. The latest signal suggests that traders have reached a short-term extreme in fear which supports a move to the upside.

VIX Divided by Five-Year Treasury Yields

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We also look at a ratio of the VIX divided by the five-year Treasury yield. Strong surges in the VIX/five-year ratio show that traders are fearful, and they're moving toward short-term bonds in a "flight to safety." This ratio has currently climbed to the highest readings since the 2002 bear market lows.

The sentiment backdrop is in place for a bear market low to be made. The extreme oversold readings in our internal indicators combined with these sentiment readings support the idea of a bottom being developed in the markets. These are not precise timing indicators, but they do give traders a reference point to hold onto and start looking for the turn in the market to be made.

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At the time of publication, John Hughes and Scott Maragioglio had no positions in the stocks mentioned. Hughes and Maragioglio co-founded Epiphany Equity Research, which has developed and utilizes proprietary tools to identify and track liquidity changes in the market indices and sectors. Hughes advises numerous asset managers, hedge funds and institutions managing in excess of $30 billion. Maragioglio is a member of the market technicians association (MTA) as well as The American Association of Professional Technical Analysts (AAPTA) and holds a Chartered Market Technician (CMT) designation. Maragioglio has also served on the board of directors of the AAPTA.