Bullish Sentiment Explodes; Should You Worry?

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by: Clif Droke
Summary

Investor sentiment spikes to a historically dangerous level.

While this could have intermediate-term repercussions, there is no need for panic.

Short-term uptrend should remain intact regardless.

By now, the bears have undoubtedly proclaimed from the housetops the latest results of the American Association of Individual Investors (AAII) sentiment poll. On Jan. 4, the AAII survey revealed that 60 percent of its members were bullish on the stock market. This was the highest reading of bulls since 2011, and only the second time in over 11 years that the percentage of bullish investors has been anywhere near 60 percent.

Bearish analysts are undoubtedly celebrating this latest burst of exuberance on the part of individual investors. A high percentage of bulls (i.e. anything above 50 percent) are considered to be a danger signal for the stock market, from a contrarian perspective. Whenever investors are this bullish it has often coincided with major market tops. It is also commonly assumed that whenever AAII bullish sentiment exceeds 50 percent for more than a couple of weeks that the short-term stock market trend is in serious danger. This is not always the case, however, as we’ll discover in this commentary.

Chart created by Clif Droke

With the AAII bulls now up to an extremely high 60 percent, it does suggest that too many participants have become enamored with equities. This in and of itself can be a dangerous sentiment for the interim market outlook. For instance, on Dec. 22, 2010, the AAII bulls were 63 percent – the highest reading of the last 11 years. Yet even after this burst of enthusiasm, the stock market as measured by the S&P 500 (SPX) continued to make higher highs for four more months before finally peaking. The peak for the stock market was achieved on the first day of May 2011, after which the market tanked about three months later (see graph below).

S&P 500 Index, 2010-2011

Source: www.BigCharts.com

The next time the AAII bulls reached the 60 percent level was on Nov. 12, 2014. Again, the actual stock market peak didn’t occur until several months later in 2015. Yet the spike in bullish sentiment in November ’14 marked the beginning of an important transition in the character of the stock market. Prior to that point, equity prices had experienced a strong two-year period of growth. After November 2014, the market became much narrower and investors were forced to become selective in their selection of stocks since fewer industries had the benefit of forward momentum.

S&P 500 Index, 2014-2015

Source: www.BigCharts.com

In both cases then, a spike of the AAII investor bullish sentiment level to around 60 percent served as a preliminary warning that the market’s intermediate-term (4-9 month) trend was in the process of changing. In neither case, however, was the bullish percentage spike a warning that a stock market reversal was imminent or that the short-term (1-3 month) trend was in any danger.

Bull markets take time to reverse, especially when they are supported with a backdrop of strong corporate fundamentals and internal health. Such is the present case with the NYSE broad market. Therefore, the latest spike in AAII bullish sentiment shouldn’t be viewed with alarm, but rather as a possible “heads up” that the intermediate-term upward trend may begin slowing down in the coming 4-9 months.

Indeed, the current technical backdrop for the NYSE broad market remains quite supportive of rising prices. As discussed in my previous commentary, the three primary components of what is commonly referred to as the “tape” – breadth, volume, and new highs-lows – are still in a decisively rising trend.

If the stock market’s intermediate-term trend was in any danger of reversing, it would first be signaled in these three indicators. That is, the NYSE advance-decline (A-D) line, the cumulative advance-decline volume line, and the cumulative new 52-week highs-lows line would all be trending lower. Presently, all three are in a synchronized rising trend as featured in my previous commentary.

Most important of all is the new highs-new lows for the NYSE. This indicator has been the key for the bull market phase, which began in January 2016. It reveals the incremental demand for equities on an aggregate basis and is the single best barometer for gauging broad market internal health that I’m aware of.

As long as this line is rising (below), the implication is that insiders and strong-handed investors are still bullish on equities and that’s all that really matters for the short-to-interim market outlook. Only when this indicator reverses its upward trend should investors begin to worry that perhaps the broad market uptrend is in any kind of danger.

Chart created by Clif Droke

Notwithstanding the conspicuous increase in bullish sentiment, investors should remain bullish on the equity market outlook as we head into what should be another winning year for the S&P 500. While it’s possible that the upward trajectory of the SPX will slow later in the year, the odds still technically favor higher prices ahead for stocks.

Disclosure: I am/we are long ROBO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.