This story was originally published on RealMoney on June 29 at 9:51 a.m. EDT.

My "Wrong Money Indicator," which measures investor sentiment, has moved to a bullish extreme. While most would interpret this as a bearish signal, the data really does not support that notion. However, under certain circumstances, excessive bullishness can be a very good sell signal, and the current market environment may be replicating such circumstances.

Let me begin by explaining this indicator. It measures the opinions of those investors who are typically wrong on the market: the investors who are zigging when they should be zagging.

The indicator identifies statistically significant extremes in four different sentiment measures and combines them into one composite value:

  • Chartcraft's Investors Intelligence poll, which seeks market opinion from newsletter writers.
  • The American Association of Individual Investors poll, which surveys individual investors.
  • The Market Vane Bulls, which polls investment advisers.
  • The put/call ratio, which attempts to quantify the behavior of option players.

The "Wrong Money Indicator" is shown in the chart below. Weekly price data for the

Nasdaq Composite

are in the chart's top panel. When our four "wrong way" numbers are bearish on the market, the indicator is green, and this is a bullish signal. When the indicator is red, the herd is too bullish, and this is a bearish signal. But is this really true?

Looking at the chart, it's obvious that there have been many times in the past where sentiment was very bullish (i.e., the indicator is red) and prices continued to motor higher. As a matter of fact, if you just bought and sold the Nasdaq when the indicator was red (bullish sentiment, bearish signal), you would have made very impressive gains. These results are shown in the table below under the column System 1.

The Wrong Money
This indicator is at a bullish extreme now

Click here for larger image.

Source: TradeStation

With 33 trades in 15 years, you would have made 1,005 Nasdaq points. The strategy doesn't beat buy and hold, and I believe this is because of limited time in the market. But it should be clear that buying when sentiment is bullish (a bearish signal) can be a winning strategy.

Maybe you are thinking that my indicator just isn't that good, or that bullish sentiment (bearish signal) is just a different creature from bearish sentiment (bullish signal) because of the long bias to the market. These certainly are possibilities.

Even if we buy the Nasdaq when the composite "Wrong Money Indicator" gets to an even more bullish extreme (bearish signal), the results are still positive. In other words, compared with System 1, this system buys the market when sentiment is at super extremes. The performance results are shown in the column labeled System 2 in the above table.

I think I'm making my point: Bullish sentiment can be a bullish signal.

So you must be asking yourself by now, "Why measure sentiment if it doesn't work -- especially when everyone is so bullish?" It's a good question.

The Important Variable

But sentiment does work as a market-timing tool when the herd is bullish, and the reason to measure market sentiment is that it can be a very powerful tool, but only when we interpret the indicator or signals in the context of where the current price is in relation to its 200-day moving average.

For example, if prices are below or hovering around their 200-day moving average, then bullish sentiment (bearish signal) can be a very useful countertrend signal to go against the market. If sentiment is bullish (bearish signal) and prices are above their 200-day moving average, then I would ignore the signal. And the data support this notion that sentiment needs to be taken in context of where prices are in relation to the 200-day moving average.

Let's design another study that takes a short position. The first requirement of our study is that the Wrong Money Indicator be in the red zone (bullish sentiment, bearish signal). The second requirement is that the Nasdaq index closes below its 40-week moving average at a time when investors are extremely bullish. Positions were held until sentiment turned bearish (indicator is green, a bullish signal). The results of such a study are in the column labeled "short system" of the above table.

Now before you say "Wow," please realize that there were only four occurrences and all of these occurred in the bear market of 2000-2002. There was a fifth trade that commenced in July 1990, and this went for more than a 10% gain, but because of the nuances of backtesting, I am unable to capture this in the study. Though there were only five occurrences in 15 years, it should also be noted that four of these five signals identified the intermediate-term top within 1% of the highs.

So let's recap. In 15 years, there have been 33 unique times where the "Wrong Money Indicator" became very bullish (bearish signal). Of those 33 times, there are only five instances when prices went below or were already below the 40-week moving average when sentiment was this extremely bullish. Those five times -- when prices were below the 40-week moving average -- were the time to heed the bearish signal of bullish sentiment.

Now five instances aren't statistically significant, but caution should be exercised in the current market environment, as sentiment is bullish and prices are hovering around their 40-week moving average.

In a lot of respects, this whole scenario makes sense. Institutions are the elephants that move the markets, and it is classic textbook technical analysis that the 40-week moving average is the line in the sand for institutional involvement in the markets. When prices are above this key moving average, institutions are buying; below that, they are selling. Thus you can imagine what might happen if too many investors are leaning the wrong way (i.e., bullish sentiment) and prices drop below the 40-week moving average. Past instances do not paint a pretty picture.

Unsure of the market environment? Then let's make this easy and use the 40-week moving average as our guide. If at any time prices close below their 40-week moving average when there is this much bullish sentiment, you should become very defensive. There will be better opportunities ahead. If prices stay above their 40-week moving average, this could be a bullish sign despite the bullish sentiment.

Guy M. Lerner, M.D., is an anesthesiologist and a freelance writer who trades for his own account. He blends technical and fundamental analysis to determine those factors that lead to sustainable moves in the markets. Lerner's approach is research-driven and focuses on supply-demand issues, investor sentiment, intermarket relationships and monetary liquidity. He is a member of the Market Technicians Association and is the founder of

TheTechnicalTake.com

, a Web site that offers content, commentary and strategies for investors and traders. Under no circumstances does the information in this commentary represent a recommendation to buy or sell stocks. He appreciates your feedback and invites you to send your comments by

clicking here

.