- 1998: Volume 7, No. 2 Contrarian Opinion And Long-Term Market Sentiment

The theory of contrarian opinion states when market participants are extremely bullish most participants have already taken long positions. The contrarian then assumes there are very few traders left to buy. So after the first sell-off, the contrarian takes a short position anticipating the new downtrend will persist due to the lack of additional buyers. When participants are extremely bearish, most have already gotten short so there are few would-be sellers on the sidelines. After the first rally, the contrarian gets long anticipating the new uptrend will continue because of the lack of sellers.

Have Extremes in Market Sentiment Signaled Turning Points in the T-Bond Market?

To answer that question, I employed a four-step approach. First, for the purpose of this study I gauged market sentiment using the Reid Thunberg long-term sentiment index. Every week Ried Thunberg & Company (Westport, CT) asks at least 50 fixed income money managers to rate the bond market's long-term outlook from one through 100. (Long-term is considered the next four to seven months. A reading of one is the most bearish reading a respondent can have. One hundred is the most bullish. One to 49 is considered a bearish response, 51 to 100 is bullish territory and 50 is neutral.) The index equals the average rating of the managers' responses.

Next, given the sentiment index can be volatile week-to-week, I smoothed the index using a four-week moving average.

Third, I identified extremely bullish and bearish sentiment by comparing the index's four-week moving average with its 52-week moving average. When the four week average was five percent (usually about 2.5 units) or more above the fifty-two week moving average, I considered sentiment to be extremely bullish. When the four week average was five percent or more below the 52-week moving average, sentiment was extremely bearish. For example in early 1991 the sentiment index's four week average (see Figure 1, solid line) was below the fifty-two week average (middle line of channel) by five percent (lowest line of channel) on two occasions. On those occasions, sentiment was extremely bearish and the market was oversold. During late 1991 the four-week average was above the 52-week average by five percent (highest line of channel) on two occasions. On those occasions, sentiment was extremely bullish and the market was overbought.

Figure 1

Fourth, when the market was oversold and then the index's four-week average rose two consecutive weeks, I recorded the T-Bond future's price change during the following 13 and 26 weeks. In an overbought market, after the four-week average fell two weeks in a row, I recorded the price change during the following 13- and 26-weeks.

This test was conducted using data of the past 10 years. The results are tabulated in Figure 2.

Figure 2
Overbought Signals

Date	Next 13 Weeks	Next 26 Weeks
Feb 19 '88	-8-04	-8-26
Jan 13 '89	-1-13	+7-03
Jun 9 '89	+0-26	+2-24
Oct 27 '89	-5-12	-10-04
Jul 27 '90	-2-26	+1-28
Feb 1 '91	-1-11	-1-19
Sep 20 '91	+3-19	-1-18
Dec 20 '91	-5-05	-2-22
Oct 1 '93	-4-29	-14-25
Nov 12 '93	-1-31	-13-30
Dec 15 '95	-9-06	-12-31
Feb 23 '96	-5-17	-6-00
Average	-3-15	-5-02

Oversold Signals

Date	Next 13 Weeks	Next 26 Weeks
Apr 15 '88	-2-22	+0-18
May 20 '88	-0-17	+2-16
Jan 26 '90	-4-25	+0-22
Oct 5 '90	+5-10	+5-07
Apr 12 '91	-2-19	+3-15
Jul 5 '91	+7-20	+11-05
Jul 3 '92	+3-09	+2-03
Nov 20 '92	+5-26	+6-00
Apr 16 '93	+3-25	+9-24
Jul 2 '93	+5-08	+0-11
Oct 14 '94	+0-25	+5-26
Jul 14 '95	+3-10	+4-21
Jul 19 '96	+2-07	+1-28
Oct 4 '96	+2-08	-4-22
Sep 12 '97	+7-05	+7-17
Average	+2-13	+4-18

Sentiment was extremely bearish and the market was oversold 15 occasions. The T-Bond rose 11 times during the following 13 weeks and 13 times during the following 26 weeks. The average price change after those 15 oversold periods was +2-13 (2 points and 13 thirty-seconds) over the 13 weeks and +4-18 over the 26 weeks. Sentiment was extremely bullish 12 occasions. The T-Bond fell 10 times during the following 13 weeks and nine times during the following 26 weeks. The average price changes following those 12 overbought periods was -3-15 and -5-02 respectively.

These results indicate long-term market sentiment is a contrarian indicator in the bond market. Currently, sentiment is extremely bullish so the April to January rally pushed the T-Bond into overbought territory. This overbought reading indicates the correction that began in early 1998 will continue for the next few weeks as the T-Bond alleviates its overbought condition.

Alex Saitta is a technical analyst for Salomon Smith Barney. Yuxin Li, his associate, contributed to this article.