Contrarian Sentiment Points to Bearish Tilt for Stocks
Contrarian investors are struggling mightily to decide if investors are too optimistic or too worried.
Is there too much bullishness right now on Wall Street—or too much pessimism?
A lot is riding on the answer, if you—like the majority of the investment advisors I monitor—have contrarian instincts. As contrarians are fond of saying, the market likes to "climb a wall of worry." Therefore, it would be a bad sign if there were too much bullishness—and vice versa.
Unfortunately, there is nothing even closely resembling a consensus about the nature of the prevailing mood. Some of the advisors I monitor are sure that Wall Street has been possessed by nothing short of irrational exuberance, while others are amazed by high perceived pessimism.
To give two recent examples: Hedge-fund manager Doug Kass, president of Seabreeze Partners Management, for example, says we're seeing a "bull market in complacency;" while Michael Purves, chief global strategist at Weeden & Co., terms the prevailing mood a "wall of hatred."
If there is any agreement between these otherwise diametrically opposed points of view, it's that contrarian analysis is worth paying attention to—that the market tends to do the opposite of what the majority thinks it will. And it makes intuitive sense that it would.
After all, it's human nature to become more optimistic as the market rises and more pessimistic as it declines. From this simple truism it follows that optimism will be at its all-time high right at bull-market peaks—just as bear markets begin. The opposite will be the case at market bottoms.
Putting this intuition into practice is another thing entirely; however, as is well illustrated by the wide disagreement about today's prevailing sentiment. In my experience of tracking hundreds of investment newsletters for over three decades, assessments of sentiment often lie in the eye of the beholder.
All too often, the bulls who are eager to wrap themselves in the flag of contrarian analysis will see a "wall of worry" everywhere—just as the bears will be inclined to detect too much bullishness.
For the record, I am not accusing either Mr. Kass or Mr. Purves of this behavior. But it is clear that, in order to resurrect contrarian analysis from subjectivity, it's incumbent that we focus on objective measures of sentiment.
I have rigorously analyzed a dozen different sentiment measures, and only three met econometric tests of statistical significance. Each is based on the behavior of retail investors or retail-oriented advisors:
• The well-known survey of newsletter sentiment that has been conducted weekly since 1963 by Investors Intelligence. The survey places each newsletter in one of three categories: Outright bullish on the stock market, outright bearish, or long-term bullish but expecting a shorter-term correction.
• The second sentiment survey I analyzed was the one maintained by the American Association of Individual Investors. This organization's members that come to its Website are asked to indicate whether they are bullish, bearish, or neutral on the stock market. Weekly totals have been maintained since 1987.
• The third sentiment survey on which I focused was the one maintained by the Hulbert Financial Digest (HFD). It reflects the average recommended equity exposure among a subset of short-term stock-market timers who are monitored by the HFD (as represented by the Hulbert Stock Newsletter Sentiment Index, or HSNSI).
Unfortunately, all three measures show that we're far closer to the "optimism" end of the spectrum. And that's bearish from a contrarian point of view.
Consider in particular the message painted by the HSNSI, which currently stands at 63.2%. Though that's lower than the highest level this index has ever reached—which is 82.3%—it nevertheless is far higher than the norm. Over the last five years, for example, the HSNSI has averaged 38.7%.
Since 1985, which is how far back HSNSI data extend, the Wilshire 5000 has fallen an average of 3.1% over the four weeks following HSNSI levels greater than or equal to 60% -- and 6.9% over the subsequent 13 weeks.
To be sure, bullishness has been high for quite some time, and so far at least the market has defied these historical odds. But, unless you think the market's relationship to human psychology has fundamentally changed, it would seem risky indeed to bet that the bull market will continue a lot higher in the face of this high level of bullishness.
One measure of that risk: The HSNSI was also high for an equally long time prior to the 1987 Crash, for example, as well as a number of months in the summer of 1998 prior to the market's meltdown that accompanied the collapse of Long Term Capital Management.
Ned Davis, the founder of Ned Davis Research, who for several decades has also closely studied sentiment indicators, suspects that the Federal Reserve's easy money policy has played a major role in keeping the market going despite sentiment levels that normally would presage a correction. He furthermore reminds us that, even when sentiment peaks correctly presage market tops, they often can be early.
All things considered, for now he remains "neutral to mildly bullish."
But it also seems clear that market risk is high right now. As Davis also acknowledges, the sentiment data lead him to "think another 1987-type correction is possible."
