Contrarian Analysis of the Market’s Big Drop

Has the market timer community become so pessimistic that a contrarian buy signal is imminent?
Author:
Publish date:

Have the bulls run for cover in the wake of Monday’s market plunge, which took 650 points, or 2.5%, off the Dow Jones Industrial Average? And on Tuesday, the Dow fell another 222 points, or .80%

Contrarians wonder. They want to know if Monday’s big drop caused the short-term market timer community to become so pessimistic that a contrarian buy signal is imminent.

“No” is the answer, at least as judged by my index of stock market timer sentiment. While the average short-term timer isn’t as exuberant as he was just two weeks ago, he still is closer to the optimism end of the spectrum than to the pessimistic end.

A contrarian buy signal will have to wait.

I base my comments on historical patterns in the average recommended equity exposure levels of short-term stock market timers. (This average is what is reported as the Hulbert Stock Newsletter Sentiment Index, or HSNSI.) As illustrated by the accompanying chart, the stock market usually struggles in the wake of very high exposure levels -- and tends to perform well following very low exposure levels.

Hulbert Chart 102720

Though different contrarians use different thresholds to define these zones of excessively high and low exposure levels, the accompanying chart uses the top and bottom 10% of the historical distribution. In order not to be guilty of hindsight bias, the chart defines these zones with data up through 2018, and then uses those zones as the basis of a contrarian analysis beginning in January 2019.

The past two months have followed a contrarian script quite nicely.

In mid-September, as you can see, the HSNSI dipped into the bottom decile of the distribution that represents extremely low exposure levels. The Dow over the subsequent three weeks rallied more than 6%.

That rally led the bears to quickly change their tune and become extremely optimistic. By mid-October, the HSNSI was well into the top-most decile that represents very high exposure levels. Since then the Dow has pulled back 4%.

Though in the wake of this 4% pullback the HSNSI has dropped out of the extreme optimism zone, it remains well above average. Currently it is higher than 67.5% of daily readings since 2000; only when that percentage drops to 10% or below will contrarians begin to entertain a short-term buy signal.

How long will that take? Contrarian analysis says there’s no need trying to answer that question, since the market will tell its story in its own time. If we have a couple more days like Monday and the erstwhile eager-beaver bulls just as quickly become pessimistic again, then a contrarian buy signal could be just around the corner.

In contrast, a contrarian buy signal would be some ways off if the currently-optimistic market timers stubbornly adhere to their exuberance. If that turns out to be the case, the stock market’s decline will have to last longer and fall further to produce the extreme pessimism that constitutes a contrarian buy signal.

We’ll know soon enough. But, for the moment, the market timers aren’t pessimistic enough to stop the sentiment winds from continuing to blow in the direction of yet lower prices.