(Editor’s Note: Over the last few weeks the League of Power has been running a special and timely series from master trading expert Rick Pendergraft. You may recognize Rick from his numerous appearances on CNBC, Bloomberg and Fox Business News.)

“The market can remain irrational longer than you can remain solvent.”

John Maynard Keynes

The previous quote is one of my favorite quotes about the stock market. Because the market is made up of humans, there is always a certain amount of irrational thought involved in the investing process. The market environment over the past few months has been irrational in my estimation.

From the low on November 16 through the recent high on February 19, the S&P gained just shy of 14%. That is a huge gain for what amounts to one quarter. The rally was so strong, that there was only one stretch where the market went down for more than two days in a row.

While this rally was starting, the GDP growth rate in the United States was slowing from 3.1% in the third quarter of 2012 to 0.1% in the fourth quarter. Even when the original estimate came in showing a contraction of 0.1% at the end of January, investors showed little concern. I heard several explanations for the fall in production and most of the blame for the shortcoming was placed on Hurricane Sandy’s impact in the Northeast.

I live in South Florida and I would never make light of what a hurricane can do, but for people to brush off such a sharp drop in GDP growth and blame a hurricane for it is irrational. Seeing a 14% gain in the S&P during a time when the economy is limping along is irrational.

Seeing such anemic growth during the fourth quarter is only part of the problem too. Since the payroll tax cuts expired at the end of the year, consumers are taking home less money in 2013. You think that is going to help boost GDP? I don’t think so. In fact, the Personal Income report for January was released on Friday and it showed a decline of 3.1%.

Consumers are making less and will have less to spend. Now, as the sequester is set to go into effect, we will see the government having to cut back on its spending as well. The combination of consumers spending less and the government spending less doesn’t bode well for GDP growth.

With all of this going on, the market has still managed to avoid any substantial pullback over the last four months. How can that be? That is irrational.

Why did the market go up so sharply? There were more buyers than sellers. It is as simple as that. A stock goes up because there are more buyers than sellers and it goes down when there are more sellers than buyers. That is investing in its simplest form–the most basic of economic principles (supply and demand) at work. When the demand for a stock outpaces the supply, the price will rise. As for the overall market, it is simply a reflection of the demand outpacing supply on the majority of stocks.

Hopefully at this point you are saying, “yes, this is true, but how do you know when there are going to be more buyers than sellers?” This is where sentiment analysis comes in. By watching the sentiment indicators toward the overall market or on an individual stock, you can put the odds in your favor by knowing when the odds of there being more buyers than sellers.

Let me give you an example. Back in October I wrote an article for Main Street Investor entitled “Apple To Fall 10% On Earnings Despite iPad Mini”. My reasoning for such a bearish stance on one of top performing stocks of the past decade was simple–there were way more potential sellers than buyers.

Looking at three sentiment indicators, almost all investors were bullish on Apple. The short interest ratio was under one, the put/call ratio was among the lowest readings of the previous year and almost all of the analysts following the stock were bullish.

Let’s look at these indicators one by one. First, a short interest ratio measures the number of shares sold short divided by the average daily trading volume. A reading under one means that the stock sees more trading volume in a single day than there are shares sold short at the time. A low short interest ratio means there are more potential sellers than buyers.

Second, the put/call ratio tells us what option traders are doing. Puts are bearish bets that make money when the stock goes down while calls are bullish bets that make money when the stock goes up. A high put/call ratio reflects a bearish stance toward the stock while a low one reflects bullish sentiment. Apple’s put/call ratio was low at the time.

Lastly, the analyst ratings toward a stock tell you the likelihood of the stock getting an upgrade or a downgrade. In the case of Apple in October, there were 49 “buy” ratings, four “hold” ratings and two “sell” ratings. With 89% of analyst rating the stock as a “buy”, the odds of a downgrade are 9 to 1 over an upgrade. Or at least that is how I view this indicator.

Since I wrote that article, Apple has fallen another 30%. So my prediction was off on how much the stock could lose, but the fact that I was bearish while almost everyone else was bullish shows you the power of sentiment analysis and how effective it can be.

While I think the sentiment toward the overall market is way more bullish than it should be at this point in time, it isn’t nearly as one-sided as the sentiment toward Apple was in October. I do think the market is overdue for a substantial pullback, but it should be within the confines of the long-term uptrend in the market.

I wouldn’t rush out and sell all your stocks, but I would take some action that allows you to protect your downside risk- take some profits off the table, buy some protective puts or add an inverse ETF to your portfolio as a hedge.

Regards,

Rick Pendergraft