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Optimism Getting Worrisome

While sentiment gauges aren't sky-high, some experts say investors are <I>too</I> cheerful.

Investor sentiment measures don't show the stock market bubbling with enthusiasm to the degree that some skeptics might have you think. But, if you subscribe to the contrarian theory that the masses are usually wrong, the measures do suggest bullishness has risen to a level at which stocks could have trouble making significant headway in the months ahead.

"Sentiment is definitely a problem for the near term," says Richard Dickson, technical analyst at Hilliard Lyons. "There are a lot of measures at levels that have been a cause for concern in the past."

The way sentiment is supposed to affect the market is easy to grasp. When investors are screamingly bearish and strategists are urging you to hoard canned goods, the theory says that just about all the bad news has been priced into stocks. It's a fine time to buy. Conversely, when people chirp stock market arcana in the checkout line and portfolio managers chat about how earnings aren't relevant to their stocks' valuation framework, it might be a good idea to sell.

VIX Vapors

Such evidence isn't very scientific, however, so people have devised a number of surveys and market gauges to measure how cheery investors are toward stocks. These days the one that probably gets the most attention -- because it has lately been the best market-timing tool -- is the Chicago Board Options Exchange Volatility Index, or

VIX. The VIX measures the premium investors are willing to pay for S&P 100 index options. When investors expect volatile markets -- in general, when they're bearish -- that premium, and the VIX, rises. It's a buy signal to contrarians.

The VIX's most recent major high came Sept. 21, when it hit 57. Since then the benchmark

S&P 500 has advanced about 20%, and the VIX has steadily fallen. Today, it stands at about 24 -- a level at which, over the past year, it has been a good time to sell.

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But other measures of sentiment are mixed. The ratio of

put options to

call options, for example, is not at the kind of lows associated with undue optimism. (Investors buy puts when they think stocks are going down, calls when they think stocks are going up.) Surveys are tending to optimism, but the overall picture, according to Ned Davis Research equity strategist Tim Hayes, is not of excessive bullishness.

Ad Absurdum

"We have relatively high optimism," he says, "but it's not at real danger levels." Hayes also says that optimism tends to manifest itself well before the market peaks. Moreover, a high degree of optimism isn't as pure a sell signal as a high degree of bearishness is. As anyone who was around just two years ago can recall, investors can go from excessively bullish to astoundingly bullish to absurdly bullish before stocks begin to fall.

A final measure of sentiment -- again, a tool based on contrarian theory -- has been developed by Merrill Lynch chief U.S. strategist Rich Bernstein, and it has been flashing sell for a long time.

Bernstein's "Sell Side Indicator," based on the allocation recommendations of major Wall Street firms, shows that stock market strategists continue to think you should be more heavily invested in stocks now than they've thought at just about any time in the past 16 years. The indicator is only fractionally below the all-time high it hit in July -- in part, because Merrill Lynch's newly appointed chief U.S. strategist recommends a significantly lower stock allocation than his predecessor did.

Bernstein continues to believe that "bottoms are characterized not by negative sentiment, but by a lack of sentiment. We haven't had that lack of caring that would signal a true market bottom." Perhaps the day that you mention market sentiment and nobody understands what you're talking about will be the sign of the true investment opportunity.