Extreme greed in the stock market is producing a bad setup as earnings season starts

Earnings are the single best guide in the stock market in the long term.

In the short term, sentiment rules.

Only 8% of the strong move up in the stock market last year was attributable to earnings. The rest was triggered by the Federal Reserve reversing its policy of raising interest rates, which boosted sentiment, especially among the momo (momentum) crowd.

In short, sentiment is driven by fear and greed. The CNN Fear & Greed Index stands at 90, representing extreme greed. Our proprietary sentiment indicator at The Arora Report differs from CNN’s conclusion in that the stock market is not yet at an extreme bullish level; it is approaching the extreme zone.

Earnings season is starting. And this level of greed is producing a bad setup. Let’s explore the issue with the help of a chart.

Read: Why the Dow’s top 20 years ago is a warning for stock investors today

Chart

Please click here for an annotated chart of Five Below FIVE, +5.32%.

Note the following:

• Five Below is a high-flying retailer that is considered Amazon-proof.

• For a retailer, the stock is very expensive, trading at a trailing price-to-earnings (P/E) ratio of 39.

• The chart shows that the stock gapped down 14% after the company reported poor earnings. On Tuesday morning the stock rebounded, rising over 4% as of this writing.

• In a normal market environment, an expensive retail stock like Five Below would have continued to fall after the gap down at the open.

• Similar behavior happened in Abiomed ABMD, +1.33%, a medical-device company, after it reported poor earnings.

• Delta Air Lines DAL, +4.38%  reported earnings that were better than the whisper numbers. But that is a special case because the airline is benefiting from the trouble of other airlines related

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