Why Too Many Bears Can be a Good Thing for Stocks

Last week in Money and Markets, I pointed out why bad market breadth is a warning sign for stocks. In addition to market internals, like advancing versus declining stocks plus new highs and lows, another key factor to keep a watchful eye on is: sentiment.

Stocks have been locked in a frustrating trading range all year. In fact, it’s been the most do-nothing, range-bound market I can remember in the 30 years I’ve been in this business.

For instance, when the S&P 500 Index dropped below its 50-day moving average early this week, it was the 31st time this year stocks crisscrossed that key technical level, which defines a market uptrend versus a downtrend.

You have to go all the way back to 1933, in the midst of the Great Depression, to find a year with more up and down swings. And that dubious record is almost certain to fall this year, with nearly five months remaining in 2015!

With the trend in stocks so undecided, investors are becoming paralyzed with indecision themselves, and that is showing up in several market sentiment gauges I watch closely.

Take a look at the graph below, courtesy of Bespoke Investment Group and you’ll see what I mean.

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The graph plots survey results from the American Association of Individual Investors, which has been polling investors for decades about whether they are: bullish, bearish or neutral on stocks over the next six months.

As you can see, bullish sentiment has been falling fast, dropping for 18 straight weeks, to just 21% last week. That’s near the lowest level of the past several years.

According to AAII, the long term average bullish reading from Main Street investors is nearly 40%, so we’re at just half that level right now. On top of that, the percentage of bears jumped to 40.7% last week, the most in nearly two years.

This pervasive bearishness might sound alarming at first blush, but like most sentiment measures, this is a contrary indicator. When there are too many bears, there may be no one left to sell, so that may be the best time to buy!

But it’s not just mom-and-pop investors who have turned bearish on this trading range market, the Wall Street pros have too, and this is an even more profitable contrary buy signal!

Merrill Lynch conducts a monthly sentiment survey of its own: The Sell Side Consensus Indicator. They essentially hold up a mirror to their own industry peers by polling the average equity allocation recommended by Wall Street brokers.

And it’s no surprise that Wall Street’s consensus view has proved to be a reliable contrary indicator historically.

In other words, it’s bullish for stocks when Wall Street’s best and brightest get too bearish about the market. And when Wall Street turns extremely bearish, it has been a reliable buy signal in the past.

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As shown in the graph from Merrill above, this contrary indicator is on a buy signal right now. In fact, Wall Street’s bearishness is even more extreme now than at the market lows in March 2009. The only time it was more bearish (i.e. bullish for stocks) was 2012, not long after the last significant stock market correction of nearly 20% in 2011.

Based on Merrill’s research, whenever the indicator has been this low or lower in the past, stocks have moved higher 97% of the time over the next 12 months, posting a median gain of 25% or more!

Now, these sentiment indicators don’t mean stocks can’t go lower near term. After all, it’s been over three years since the S&P 500 registered a correction even close to 10%, so we’re certainly overdue.

But what these sentiment indicators do tell me is that investors on Main Street and Wall Street alike are getting worn out by this do-nothing, trading range market. And with pessimism on the rise, it’s getting more and more likely that we will see a great buying opportunity at some point this year. So keep some dry powder and stay tuned.

Good investing,

Mike Burnick

Mike Burnick, with 30 years of professional investment experience, is the Executive Director for The Edelson Institute, where he is the editor of Real Wealth Report, Gold Mining Millionaire, and E-Wave Trader. Mike has been a Registered Investment Adviser and portfolio manager responsible for the day-to-day operations of a mutual fund. He also served as Director of Research for Weiss Capital Management, where he assisted with trading and asset-allocation responsibilities for a $5 million ETF portfolio.