Bad Sentiment Is Good for Stocks

02/26/2008 12:00 am EST

Focus: MARKETS

John Bollinger

President and Founder, Bollinger Capital Management

John Bollinger, editor of Capital Growth Letter, says investor sentiment is at rock-bottom levels, and that’s usually a good time to buy stocks.

After the psychological pounding investors and traders have taken, they simply do not believe in the upside. Insurance, not speculation, is the name of the game. This is exactly the behavior one would expect to see in the wake of a correction as a recovery gets under way. We regard this lack of belief in the upside as quite bullish.

We are convinced that January 21st, 22nd, and 23rd were the days of peak downside intensity and that the correction is behind us. One very important reason is that it was on those days that Societe Generale liquidated its losing 4.9-billion Euro position in stocks.

Another reason for our growing bullishness is the sentiment data. Looking at the International Securities Exchange (ISE) Sentiment Index, we see that the [data] have fallen into historically bullish territory and now forecast higher prices. Indeed, the 50-day series hasn't been this low since 2002. This series is one of the best new market-timing tools.

A recent Merrill Lynch survey shows investors being the most risk-averse they have been in the past seven years. This survey is particularly interesting as it paints a picture of professional sentiment. Another take comes from the Investors Intelligence survey of investment advisor opinion, which now depicts equal numbers of bulls and bears. The last time that was true was at the June 2006 lows. Taken together, these sentiment indictors present a picture of negativity that is quite bullish for stock prices.

The correlation between stocks and bonds is running at a significant negative number, which confirms the idea of a flight to safety and the avoidance of risk disclosed in the Merrill Lynch survey.

The most interesting aspect of current market action is the emerging leadership of small-cap stocks. Over the past couple of weeks this key sector has turned higher against the market as a whole. The relative strength line of the Standard & Poor’s 600 small stocks against the S&P 500 turned higher on January 14th and has been working its way higher ever since.

This could become a very important trend if it proves sustainable. Periods of outperformance by smaller stocks are typically good periods for the market as a whole, just as periods of outperformance by growth tend to be associated with rally phases. And speaking of growth, growth stocks are continuing to outperform value in all size ranges.

We increased the allocation for stocks to 65%, and that is the maximum level we are currently contemplating for this swing. It is down in the trenches in the wake of declines that real money is made.

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