The stock market has gotten ahead of itself, and so a short-term pullback is now likely.
I say that not because of any insight into the progress of the Covid-19 pandemic, vaccine development, or Congressional negotiations over a possible stimulus package.
My comment instead is based on the extreme bullishness among short-term stock market timing newsletters. According to an indicator that my firm maintains, stock market timers, on balance, are now more bullish than on 92.5% of the trading days since 2000. Their extreme bullishness is not a good sign, according to contrarian logic.
The indicator to which I refer is based on the average recommended equity exposure among nearly 100 short-term market timers. This indicator, known as the Hulbert Stock Newsletter Sentiment Index (HSNSI), is plotted in the accompanying chart. Right now, the HSNSI stands at 63.3%.
(Click here to read more about how my firm calculates the HSNSI.)
The areas shaded at the top and bottom of the chart represent the sentiment zones of extreme optimism or pessimism. I defined these ranges with pre-2019 data to insure we weren't guilty of hindsight bias in pointing out how they performed in 2019 and so far in 2020. Notice that the stock market struggled in the wake of each occasion when the HSNSI rose into the zone of extreme bullishness, and performed well in the wake of extreme bearishness.
This is exactly what contrarian analysis would have us believe, of course.
Notice also that the HSNSI in the past couple of days has risen into the extreme bullish zone. This is why the market’s short-term outlook is now below-average. The last time the HSNSI was as high as it is now was in the week prior to its bull market high on Feb. 19. We all know what happened next.
How poor are the market’s prospects? By way of an answer, take a look at the table below, which reports the stock market’s performance in the wake of past HSNSI readings in the extreme bullish or extreme bearish zones. The table shows this for both the broad stock market (as measured by the Wilshire 5000 Total Stock Market index) and for the small-cap sector (as measured by the Russell 2000 Index). I report returns for this latter index because this sector is particularly sensitive to changes in retail investor sentiment.
|Extreme bullishness (The 10% of days since 2000 in which the HSNSI was highest)||Extreme bearishness (The 10% of days since 2000 in which the HSNSI was lowest)|
Average Wilshire 5000 gain over subsequent month
Average Russell 2000 gain over subsequent month
Average Wilshire 5000 gain over subsequent 3 months
Average Russell 2000 gain over subsequent 3 months
To be sure, all the usual qualifications need to be kept in mind. No indicator is right all the time; sentiment is not the only thing that makes the market go ‘round. And even when sentiment-based forecasts turn out to be right, it can take several weeks for the market to eventually succumb. So by no means should you throw caution to the winds.
Nevertheless, assuming the next couple of months live up to historical precedents, the stock market will be facing some stiff headwinds.