Thursday, January 31, 2013

AAII Bullish Declines From 52% - Watch the Divergence

American Association of Individual Investors (AAII) bulls hit 52% a week ago (January 25). Today, the number has declined to 48%. The main point is to say that this is now a headwind for prices, not necessarily an imminent turning point. Two other points:

First, 52% bull is an extreme for this measure. The normal bounds are 25% (bearish sentiment) to 50% (bullish sentiment). Looking at the chart from Bespoke below, bearish extremes are cleaner indications of a turning point than bullish ones. When there are a lot of bears, you have a nice tailwind for a run higher in price.

Second, when looking specifically at tops, instead of looking for sells-off right at an extreme, look for a divergence. In other words, bullish sentiment usually declines ahead of price. So, having seen an extreme in bullish sentiment, be on the alert for the divergence and then a correction. The same divergence is found in NAAIM and put/call ratios as well. It makes sense, as part of the herd peels off before the remainder.