Is the Lack of Bearish Sentiment Bearish?

By Tiho, Short Side of Long

It has been awhile since I discussed equity market sentiment and that is because not much has changed. Bulls continue to get more bullish, the sun is shining and everyone is singing “Kumbaya my lord“. It is worth noting that overly optimistic readings we saw earlier in the year have put a stop to a rally in variety of risk assets, including:

Eurozone Equities & Emerging Markets
European Euro & Canadian Dollar
High Grade Copper & Brent Crude Oil

Therefore, if you live outside of US, your local equity market has most likely already started to decline. On the other hand, to everyone’s amazement, the US equity market has continued to rise all on its own in vertical fashion and therefore deserves a nickname “Teflon Rally”. But can the S&P 500 stay bullet proof all on its own?

I personally doubt it. I have been bearish on the equity markets since the later parts of 2012 and yet the rally continues higher, so I won’t blame you if you are sick and tired of hearing me warn about the potential sell off.

Nevertheless, all of the warnings remain in place and sentiment conditions continue to worse (indicators point to a contrary outcome). The latest sentiment update will be arriving later on today (early morning US time), courtesy of Investor Intelligence, so I thought it would be nice to include it as today’s chart of the day. Chart 1 shows that the current level of bearish advisors has fallen to alarmingly low levels, commonly linked to major market peaks. A quick glance at the chart shows similar readings in 2007, 2010, 2011 and presently.

One of the recent Merrill Lynch research notes I received in my inbox actually discussed the same sentiment conditions, so it is worth sharing. The table above shows a two decade historical study of Investor Intelligence bearish readings relative to the equity market performance. The study assumes that when bearish readings fall below 25%, equities are considered to be overbought.

From the data above, we can make a few interesting observations:

1)  The current duration of complacency seems to be the longest in two decades and has also registered the lowest reading of all the previous conditions.
2)  Apart from the tech euphoria of 1998, the equity market tends to peak within a few days to a few weeks after extreme bearish readings occur.
3)  The average and median decline following such a streak of complacent readings by II Bears indicates a high possibility of a bear market (20% decline from peak to trough).

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  • kk

    Sorry to disagree, but I don’t see a whole lot of bullish sentiment in this market. Volume is tepid, and flows to equities are puny. The financial advisors that I know (I am in the business), are by and large still afraid of the market, and at the current time, have not committed a serious allocation to the equity markets. Also, many folks are expecting, and hoping for a correction, because they need it.

  • belsha

    @kk

    You provided anecdotal evidence that sentiment isn’t overly bullish, based on your own personal acquaintances, which might not trump statistical evidence based on larger samples as “Investor Intelligence” surveys. Then again, your own statement provides just as anecdotal evidence to the bear case, i.e. in favor of overly bullish and complacent sentiment.

    One reason volumes might be so low, is simply that there isn’t any cash left as everybody has used all the margin in their accounts already….

  • http://pragcap Michael Schofield

    I cashed out of my momentum stocks late last week and early this week. I’m 90% cash and holding a few defensive-type names. Considering myself a trader, I don’t mind waiting to see what the market does next and then reacting, although I don’t see the next move being down as a given. We are clearly stuck in a range and anything is possible, so now is not a good time to make bold moves, hold cash if you have it and maybe raise a little if you don’t. All indications are that the economy and profits are in fair shape so this is probably not a time for longer term investors to dump shares.

  • kk

    Belsha, I hear you loud and clear. As an investor, I have to think for myself, which means a lot of information is in fact anecdotal.

    I mean really, do we need for Case Shiller to tell us empirically that real estate is rebounding, AFTER building material & home building stocks have already advanced 200%-400%, or that two years ago in Phoenix, one could buy a house for 30% of replacement value?

    Low volume might be a symptom of people still being fearful, and not understanding that 0% and nominal principal protection offered by cash equals guaranteed loss.

  • Advertising

    Funny to see “End of America” ad on the site…

  • Frederick

    Those are google ads. I don’t think CR has any control over them since they’re probably displaying when his ad network doesn’t have any inventory.

  • Geoff

    Ya, the “End of America” ad probably shows more about your web surfing habits than anything else. You must be reading some perma-bear sites :)

    The ads I see on Cullen’s site are normally young ladies in various states of undress. Perhaps I need to change my own surfing habits.
    Especially when I’m at work ;)