As promised in yesterday’s newsletter, I want to document (and explain) how and why I use the ISE exchange’s sentiment index to spot instances where the stock market is likely to make a reversal. The predictive qualities of the sentiment index aren’t perfect, but they’re definitely helpful when other tools are unclear about a market trend’s longevity.

What is it? In a nutshell, the ISE Index measures broad bullishness or bearishness by calculating the ratio of how many puts (bearish) are traded on any given day versus how many calls (bullish) are traded on the same day. The ‘index’ is actually a call/put ratio of opened option positions - closing trades don’t count. (Don’t worry about the difference if you’re not familiar with options trading mechanics - it doesn’t affect the use of the tool.)

Why is it important? Most of the time, it’s not. Most of the time the call/put ratio is at or near an average reading. Every so often though, the ISE Sentiment Index gets crushed or spikes. Those are the instances I’m interested in.

A low call/put ratio means a lot more puts trade than calls, which indicates a great deal of fear or pessimism. A high call/put ratio suggests traders are bullish, since they’re more interested in bullish positions than bearish ones.

Here’s where it gets interesting though….I’m bearish when the ISE Index is swollen with bullish optimism. I’m bullish when the ISE Index shows an incredible amount of fear by plunging.

The philosophy is called contrarianism - taking the minority side of market opinion. The smaller the minority, the stronger my stance is against the majority.

Why? In my experience (though not just mine), the majority of the market is usually wrong at the worst time to be wrong. In other words, most investors are terrified right as stocks hit a low. And, most investors are ridiculously optimistic and bullish right as stocks are making a peak.

Most of you all know by now I assume nothing; many ‘obvious truths’ about stocks are just flat out wrong. The only reason I’ve bought into contrarian strategies is because they work - I’ve personally tested the theory and come up with my own evidence.

I’m not going to dive into the details of my work…I don’t need to. Just understand that the contrarian use of the ISE Sentiment Index has worked far more often for me than not.

On the chart below I’ve plotted the S&P 500 along with all the ISE Index data I had access to…back to early 2002. To spot the strong peaks and plunges in the ISE sentiment data, I wrapped them with Bollinger bands. When either of the Bollinger bands is touched, I know an extreme reading has been made. (Bear in mind that ‘extreme’ is always relative, which is why I like to use an adaptive tool like Bollinger bands.)

Each low and each high for the ISE Sentiment Index has been marked with an arrow, and a corresponding ‘buy’ or ’sell’ has been marked on the S&P 500 chart. The image tells the tale.

The tool is better suited at spotting bottoms than tops…a natural tendency during a bull market. I suspect the tool will do quite well at spotting the tops within a bear market. Even then, the peaks in the ISE Sentiment Index still spotted most instances where a strong rally was about to weaken.

Perfect? Nope - nothing is. However, I’d much rather have this information than not have it. I can see things with this data that don’t show up on the index charts alone…like the mis-timed fear and greed of the masses.

If you’d like to learn more, or follow the ISE Index for yourself, click here.

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