When I first started trading, the seasoned hands in the pits used to proffer this advice: “Kid, watch the small-lot traders. Whatever they do, you do the opposite.” The theory behind the advice was pretty simple: Small traders were uniformed or otherwise unsophisticated, so they were likely to be wrong more times than they were right.
This contrarian notion took hold on a lot of traders, most particularly Jake Bernstein, whose trading history goes back more than 50 years. Bernstein’s approach to assessing small trader sentiment was through a daily poll, the results of which ultimately became the Daily Sentiment Index, or DSI. Simply put, the DSI is the degree of bullishness among small traders. A DSI reading of 90, for example, indicates that 90 percent of poll respondents are bullish; only 10 percent are bearish. Bernstein calculates DSIs for 40 different markets, from U.S. Treasurys, to stock indices, to precious metals and more.
“A high percentage bullish response rate,” says Bernstein, correlates with or leads market tops and vice versa for low percentage readings.” Generally speaking, a reading above 75 indicates toppiness while a DSI less than 25 denotes bottoming.
“We find the correlations strong enough to allow the use of DSI as a leading indicator and as a timing tool,” Bernstein declares. He’s quick to point out that DSI isn’t the end-all, be-all of market indicators. “DSI is not perfect. However, it does have immense value as a warning system.”
Perfect or not, the DSI for gold has been sounding a klaxon for more than a month. Small traders have turned bearish on bullion in a big way. Just look at the DSI’s three-day moving average in the chart below. It submerged below 25 in early May and has been under water ever since.
So, should we heed the warning? Are small traders too bearish? Well, over the past year, their overexuberance and anxiety—made manifest in DSI excursions above the 75 level and below 25—have signaled $100+ turnarounds in gold’s price.
“Current DSI readings in gold suggest excessive small trader negativity,” says Bernstein. “Pragmatically, the DSI is telling us to be careful being short this market and to look for timing triggers on the long side.”
Given the depth of small trader bearishness, any rally could be explosive. Bernstein sums it up this way: “DSI is like a weather report. Prepare for the weather or risk being a victim.”
Brad Zigler is WealthManagement's Alternative Investments Editor. Previously, he was the head of Marketing, Research and Education for the Pacific Exchange's (now NYSE Arca) option market and the iShares complex of exchange traded funds.