With market sentiment tilted towards the bears, a wall of worry is up. Why is a “wall” up, and how could it push stocks higher? Let’s discuss, because all roads lead back to market sentiment.
Why a wall of worry is up
Here at Explosive Options, we use market sentiment to help us find entry and exit points (into/out of trades). I am a contrarian trader, and that means I look for sentiment readings that are tilted bearish or bullish. Recently, the American Association of Individual Investors (AAII) released their sentiment poll. It was heavily skewed to the bear side. On the flip side, the bull reading was extremely low. The last time the poll had these readings was in December 2018.
We all remember what happened last December. Markets were slammed mercilessly following a policy error by the Federal Reserve. The Fed raised rates a fourth time, believing they were fighting inflation. Traders revolted, and the markets plunged.
Sentiment turned sharply then and it will now – eventually. Traders and investors are worried about the economy. There’s plenty to be nervous about. (You can find the full list in last week’s blog post.) Even though Q3 earnings season is underway and some seasonally strong trends are in front of us, it’s not enough to break down that wall of worry.
Additionally, the AAII is not the only bearish sentiment reading out there. The put/call ratio has been climbing, which means investors are buying protection against a potentially precipitous drop.
How the wall could push markets higher
Markets are within striking distance of all-time highs. Breadth is solid and companies are releasing decent earnings reports. Even though the markets lack momentum (stocks are stuck in a range), the amount of dry powder (money) sitting on the sidelines could act like bone-dry tinder.
I’m not the only contrarian trader out there. It doesn’t matter if market sentiment is bearish. If all that money jumps into the game at once, markets will go higher.
This doesn’t mean you should jump in feet first! Continue a cautious approach to trades, and carry some protection just in case the markets have a meltdown. The markets have been in this area a couple of times this year already, and each time they fell. Because the wall of worry is up, this time could be different.