How Deep The Pullback? Sentiment Holds The Key

There isn't much in the way of market moving news this morning. Our markets are lower, mostly taking their cue from overseas markets, which sold off again overnight. Shanghai fell -4.3%, with Hong Kong and Japan lower as well.

We got some solid earnings reports from Hewlett-Packard and Deere, but they aren't having much effect on the market. That said, so far this pullback has again been rather mild. I'm not saying its over, but given how overbought the market had become, I'm sure the bears were expecting a sharper correction.

From my perch, I think it all comes down to sentiment. The market had a fairly significant correction in July, with the S&P 500 retreating 9% from its highs to lows. But sentiment became highly bearish in short order, and the market rebounded and experienced a strong relief rally.

Could the same thing happen again? I doubt it will occur in the same fashion, but first we need to see how the sentiment indicators shape up. Many of them have moved too far in the complacent camp, and if that complacency persists, then any correction could last longer.

Here is a look at a few of the indicators I monitor:

• Investor's Intelligence survey: The spread between the bulls and bears hit +28% recently. This is the highest level since January 2008. Note that in July the spread moved back to +0%, so this indicator bears watching.
• AAII: this survey of individual investors bounced around more, but it recently hit +18%, its highest reading since May 2008. In July, it was deep in negative territory (more bears than bulls) at -27%.
• Rydex Nova/Ursa: this ratio measures assets flowing into the bullish Rydex market timing funds vs. the bearish funds. It recently fell to .56 after rising to .95 in July (a higher reading means more assets flowing into the bearish funds)
• 10-day put/call ratio: this is an options indicator of bearish put buying vs. bullish call buying. It currently stands at .81, which shows a little complacency. In July, it rose to .97, which showed far more skepticism.

As the market pulls back more, I will be watching to see if these indicators show rising levels of pessimism among investors. If that happens, then I would expect the pullback to be of the shallow variety again. Many pundits are warning about the fact that September and October are historically the worst months for the stock market. But if the market pulls back ahead of those months, and everyone is already hunkered down in their fallout shelters, the expected result might not come to fruition.

This is why I say sentiment holds the key. As we move closer to Q4, I expect some of the economic data to begin to improve at the margin. Also, as we move closer to 2010, when the economic recovery is expected to really show up, the stock market should begin to reflect stronger growth and work higher. This is why I would view any potential pullback in the market as another good opportunity to add to stocks that I think will be well higher a year from now.