Market Watch: Extreme Sentiment Often Predicts Reversals

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Includes: DIA, QQQ, SPY
by: Greg Feirman

EVERYONE SEEMS TO BE INSPECTING THE TEETH and gums of this galloping rally, searching for signs of rot and vulnerability. Haven’t the riskiest stocks led? Aren’t stocks pricing in fundamental improvement not yet evident? Weren’t all those earnings beats from cost-cutting? Doesn’t this move resemble epic bear-market fake-out rallies of the past?

Maybe. At a certain indeterminate index level, this market will have to answer to these concerns. But aside from practicing veterinary dentistry without a license, folks bringing this kind of scrutiny to every up tick in the Dow run the risk of over-thinking what the market is saying.

- Michael Santoli, “Gummy Bears” (subscription required), Barron’s, August 22

Michael Santoli writes the weekly Streetwise column for Barron’s and his column from last Saturday has generated a good amount of attention on the internet. I don’t know what to make of it except to think that it’s the kind of thing you’d expect to see written during a spectacular rally that has surprised everyone and defied all odds. That is, thinking and rationality have not paid off in the stock market over the last few months. Buying momentum and speculation have.
But sentiment has now reached a level of bullishness that often predicts a market reversal. Every month, Merrill Lynch conducts a survey of large, institutional money managers. Here are some highlights from the August survey published last Wednesday:
  • A net 75% of respondents believe the global economy will strengthen in the next 12 months - up from 63% in July and the highest reading since November 2003.
  • A net 70% of respondents expect global corporate profits to rise in the next 12 months - up from 51% in July and the highest reading since January 2004.
  • A net 34% of respondents are overweight equities - up 7% from July.
These numbers are “net” which means the bullish numbers subtract out the bears who believe the global economy will weaken over the next 12 months or who are underweight equities. These are extreme levels of bullishness.
One of the paradoxical facts about the stock market is that while sentiment data like this seems bullish on the surface in reality it is bearish. That’s because this kind of bullishness suggests most of the investment world is now fully invested with few neutral or bearish players on the sideline whose entry into the market could push stocks higher. To put it another way: Whose left now to buy? Those stubborn bears (ahem!) who haven’t bought into this rally are unlikely to change their mind at this point.
I’ve seen it time and again. In fact, I used this kind of sentiment and technical analysis last July to nail a short term bottom in the financials to the day which made me somewhat of a hero online for a bit (see “Today Is The Bottom In The Financials”, Top Gun FP, July 15, 2008). For those of you who want to learn more about investment psychology and contrarianism, I highly recommend Martin Pring’s Investment Psychology Explained.
The second piece of sentiment data that really blew me away was The Wall Street Journal’s August survey of economists. Conducted in early August, 28 of 45 economists believed that the recession was already over. Another 16 believed it would be over by the end of the year. Only one believed it would take a little longer, forecasting the recession would end in August 2010 (also see “A Consensus Among Economists: The Recession Is Over”, Top Gun FP, August 12). Where are the bears? Where is the balance? Is the weight of the evidence really so one sided and compelling?
wsj-aug-economists-survey1
Again, if everybody is bullish and invested, who is left with cash to buy? This is a relative statement, of course, but this level of bullishness suggests a lot of investors in the market who could potentially sell and very few outside of the market who could potentially buy. That’s the kind of set up that can, and frequently does, lead to the end of a move and a market reversal.
NOTE: Every week I write a Client Note for my clients. For a limited time, I am allowing non-clients to sign up and receive the Client Note. You can sign up at the top right hand corner of my website. The above, was this week's.