Don’t Outsmart Yourself with Sentimental Nonsense

11/29/2010 8:19 am EST

Focus: MARKETS

James Stack

President, Stack Financial Management

James Stack, editor of InvesTech Research, explains why bullish sentiment surveys are not the bad omen they've been made out to be.

The problem now, it seems, is that the latest rally has made everyone too bullish. At least that's the story according to the current headlines:

"'Dumb Money' Returns to Stocks," The Wall Street Journal, Nov. 8, 2010
"Market Optimism Is Ominous Sign," The Wall Street Journal, Nov. 18, 2010

A Bank of America/Merrill Lynch poll of fund managers reveals market sentiment at its most bullish level since the April peak. And surveys by both Investors Intelligence and American Association of Individual Investors (AAII) found bullish sentiment at new extremes for the current bull market.

A Stopped Clock is Right Twice a Day

But before battening down the hatches and running for cover—simply because everyone else is becoming too bullish—perhaps we should share with you the rest of the sentiment story.

Some have pointed to the recent cover of Barron's ("Bye-Bye, Bear," Nov. 1, 2010) and other institutional money surveys as evidence that bullish sentiment has reached dangerous extremes. But the historical truth is that the majority of institutional investors are correctly bullish during the majority of a bull market run. They just happen to be wrong at the critical turning points—both top and bottom.

In the last bull market, which extended from October 2002 to October 2007, a similar Barron's cover appeared in May 2003 with the following title and quote:
"A Fresh Start: Say goodbye to three years of stock market losses, the bullish portfolio managers in our latest Big Money poll declare. Why the Dow could rally 10% or more."

That poll of bullish sentiment was not only correct, but the bull market lasted three more years and the Dow gained over 65% before peaking.

The Investor's Intelligence survey of investment advisory services shows a similar leap in bullish sentiment since the August correction low. From the Aug. 26 bottom, the percentage of bullish advisors has almost doubled (from 29% to 56%). That is the highest bullish sentiment of the bull market that started in March 2009. And, as you might expect, it's creating great concern among those who follow the numbers.

Yet here again, one needs to research past data to discover the rest of the story. During the middle and latter portion of bull markets, the majority of investment advisors are "correct" in their bullish outlook. Like their institutional counterparts, they're only wrong (or most wrong) at the critical turning points.

The current 56% bullish reading is not that extreme or ominous. In fact, during the 2002-07 bull market, this Investors Intelligence survey registered a bullish reading of more than 50% for 60% of the run. And it spent one-third of the time higher than 55%.

The AAII shows an even sharper swing in sentiment since the Aug. 26 correction low. At that time, the bullish sentiment had dropped to only 21%—the lowest level since the week prior to the March 2009 bear-market bottom. Today it has almost tripled to 58% in less than three months. Sounds ominous, doesn't it? But as Paul Harvey would say, here's the rest of the story.

The AAII poll is far more volatile than any other survey we have tracked. Extremes can be important—but the bearish extremes are far more important than the bullish extremes.

When the Bears Talk, Pay Attention

In most cases when bullish sentiment drops to 20%, it's time to start thinking in the contrarian camp. However, the same is not true when bullish sentiment dominates the landscape.

The current 58% bullish sentiment might sound extreme until one considers that this same survey registered similar levels repeatedly throughout the second year of the 2002-07 bull market. In fact, if one used the "50% bullish" threshold of this sentiment gauge as a trigger to exit the market, they would have been whipsawed 13 times in the 2002-07 bull market, before the final "correct" warning in October 2007.

Bottom line, while extremes in sentiment can be a useful tool in confirming market bottoms, we have yet to find a sentiment survey that has proven historically reliable at market tops.

Both technical and leading fundamental evidence remains on the side of the bulls. The data from our good friends at the Economic Cycle Research Institute is not forecasting a double-dip recession. Consumer confidence, while nothing to write home about, is holding steady. And the ISM survey of purchasing managers is continuing to register levels consistent with ongoing recovery.

[Itching to be a contrarian? Luis Gonzalez of Kapitall.com recently listed five stocks snubbed by analysts and option buyers. Meanwhile, John Bollinger has argued that today's investors are actually much more fearful than hopeful—Editor.] 

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