9/29/2021 9:00am - Trading Lab Morning Email
Sentiment and the timing of market cycles are two of the most important subjects that an investor can study. Sentiment is NOT a market timing tool, despite the fact that many market participants use it as such.
Sentiment can remain elevated for extended periods of time, just as it can remain depressed for extended periods of time. The more elevated that sentiment is (overbullish), the more risk that tends to exist for investors who remain long the market in question. However, a topping process usually takes time. A market doesn't roll-over at the first sign of overbullish market participant sentiment; in a classic topping process the largest number of market participants will be long as the market begins making lower highs (but still relatively close to the highs that are now in the rearview mirror), then their numbers will gradually, and then rapidly decrease as prices make new lows.
The chart of the Junior Gold Miners ETF (GDXJ) in 2020/2021 is a classic example of how a bull market run, followed by a topping process, plays out:
GDXJ (2020/2021)
Gold miners reached peak bullish sentiment in early/mid-August 2020 just as prices peaked. However, sentiment remained elevated for the next couple of months as prices oscillated near the highs.
The real breakdown from the highs began in November 2020 as the Pfizer vaccine received emergency approval and the market began to see a glimmer of hope that the pandemic would end eventually, and monetary policy would begin to normalize.
It's important to emphasize that everything is very clear in hindsight, it is MUCH more difficult to accurately assess sentiment and the timing of market cycles in the present moment. Hindsight is 20/20 and everyone can read yesterday's newspaper. However, the more we study the past the more effectively we are able to act in the present.
The opposite of August 2020 in gold miners occurred in January 2016:
GDXJ (2014/2015/2016)
The January 2016 bottom in the gold sector was a memorable one because it occurred after a grueling multi-year bear market cycle. In addition, there was a 'false start' in the first few days of 2016, followed by new lows that served to wash out many market participants. This marginal new low put in place a final bear market sentiment extreme that proved to be fertile soil for one of the most explosive bull market runs in gold sector history.
Sentiment in the gold sector was extremely depressed for the final few months of 2015 and many who tried to call the bottom proved to be early, even if just by a few weeks. While many gold market commentators will claim they called the January 2016 market bottom, I didn't read a single one that called it to within a week. This is the challenge of using sentiment to time markets, one can be right within a month but during that month prices can fall another 20%, 30%, or even 40%.
Staying long a market/stock that is down 25% from your entry price in a relatively short period of time is a lot easier in theory than in actual practice - this is especially true because we all exercise some degree of recency bias i.e. prices have been falling so they will continue falling.
Sentiment is an important tool, but it's important to remember that the crowd is right most of the time. It's at the big market inflection points (like January 2016 or August 2020 in the GDXJ) that they are either caught holding the bag as prices begin to roll-over OR they capitulate and sell just before prices turn sharply higher.
