Have you ever noticed that sentiment and technical indicators are only in agreement around 30% of the time? I use both to help me understand the current market condition and guide my trades, so I certainly do! When they align, it’s a great contrary indicator.
Let’s back up a moment and explore these two types of indicators.
Sentiment tells us how traders and investors are feeling about the markets. Those feelings are very powerful. Once momentum takes over, the markets seem to ride on a very strong, unstoppable wave (bullish or bearish).
(Interestingly, sentiment is often strongest right near the end of a market trend. That’s because traders and investors do not always trust the trend until it’s well-established. Once they trust it and are ready to jump into the action, too late! The trend is about to switch.)
So, if sentiment can carry the markets longer and farther than anyone believes can happen, why even bother following technical indicators?
Technicals are objective. They provide data on the current trend and where a turn might happen; their readings are not related to moves based on feelings. Technical signals provide us with information on price, volume, breadth, and more.
For example, the oscillators (which measure breadth), relative strength (which measures momentum), and money flows (which measure accumulation) may point to an overbought condition. We know markets will soon turn based on those readings (but not when that turn will occur).
When sentiment and technical indicators align and create a similar scenario, you have a powerful combination at work. An overbought technical condition combined with bullish sentiment is a great contrary indicator. Remember, too many people leaning on one side of the boat will tip it over.
Go back to April of this year. Bearish sentiment was off the charts. The technicals were also very bearish. No one wanted to be in the game. With both sentiment and technicals keeping traders on one side of the boat, that was your sign. Cautiously start buying positions on names with strong fundamentals. If you did, your positions would have grown by 20% or more in just three months.
So, when you see sentiment and technicals align, run to the other side of the boat. It’s your sign to start positioning differently.
