Sentiment Indicators Scream Buy

This column was originally published on RealMoney on June 19 at 1:53 p.m. EDT. It's being republished as a bonus for TheStreet.com readers.

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.

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.

ISEE Level Indicative of Further Rallying?

Source: International Securities Exchange

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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.

Nonetheless, I have doubts, and I chewed this issue over with Jason Goepfert of SentimenTrader.com over the weekend. He noted how various indicators have become so widely followed that even the pure fundamentalists seem to trade off them. As such, are these tried and true indicators as accurate as they once were?

My challenge is that I sometimes catch myself trying to game the guys who are trying to game the guys who are trying to fade what the majority is doing. It's important to guard against your analysis getting too far removed from what is actually happening. What really drives the market is fairly simple: money flow from one asset class to the next; and from one sector to the next.

I try to view this dispassionately and simply focus on the money flow rather than on the fear of being wrong. It is one thing to see the data and correctly assess its import; it's another to actually act on your conclusion. Somehow, each market extreme feels different than the last.

As time goes by, our memory of how the last decline felt to us fades away, so the present selloff feels much worse. That's why we have difficulty acting on what we see. Our gut contradicts what our eyes are telling us.

So if you're feeling tentative and suspicious of this market, try to remember how you felt the last time the market suffered a serious decline. Does this selloff feel worse? If so, it's important to understand that some of the best trades are made when you go against your gut instinct. A majority of market participants have similar instincts, and the majority is always wrong at turning points. Try to step away from the emotional crowd and focus on what has proven to work in the past.

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Let's look at some stocks readers have asked about.

The iShares Dow Jones U.S. Telecom Sector Index Fund(IYZ Quote) is still up almost 10% this year. Supply at $24 has kept a lid on the stock since late 2004, but the recent pullback to that level attracted significant demand.

If you're long, there's no reason to hang up now. Consider placing a stop beneath the breakout point and be patient.

Qwest (Q Quote) churned beneath $5 for several years before finally breaking out late last year. I'd stay long and buy on dips back to support.

I've highlighted the long tail from last week's trading in BHP Billiton (BHP Quote). Both the weekly open and closer were very near the top of the range, and the intraweek range was around 10%. That's a lot of volatility in a week where volume was much heavier than average.

I'd consider last week a washout that marks the end of the multiweek pullback from $50. The challenge posed by the current level is that the stock must fall clear below last week's low before we'll know whether support will hold. That's a bit more room than I'm used to, but a scaled entry addresses that problem.

The weekly chart of McGraw Hill (MHP Quote) shows a stock in a series of higher highs and higher lows over the last year. I'd place a protective stop right under the monthly lows, just about 5% lower than the current price. That's why I see this as a low-risk long entry.

But it's important to see the big picture, too. This uptrend won't be negated until it establishes a lower low by dropping below the January low of $46. Until then, I continue to see it as a "buy on dips" stock.

To the reader with a short position in Hot Topic (HOTT Quote): I can't find a reason to cover your position. While RSI is at the low end of its range, it is far from oversold. With near-term support at $12.50 breaking down, the stock looks destined to test $10.

Be careful out there.

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