Article by Michael Brush in Market Watch
Investors and traders, it’s time to override your emotions and get cautious on the stock market.
Otherwise you might get laid low by a sharp pullback in the S&P 500 SPX, 0.68%, the Dow Jones Industrial Average DJIA, 0.60% and Nasdaq COMP, 0.51%. The stock market is much more vulnerable to one now.
There are two reasons: Crowd sentiment is very bullish, and insiders are quite cautious. This is not a good combination.
For subscribers of my stock letter, Brush Up on Stocks (link in bio, below), I regularly track a dozen sentiment indicators. Right now, all of them are throwing off a bearish signal. This means they are measuring too much optimism. That sounds good, but it is actually bearish in the contrarian sense.
After all, the crowd is often wrong. And if nearly everyone is bullish, few people are left to convert to bullishness and buy your stocks. Another problem is that overconfident investors tend to be too easily surprised by bad news. They’re sure their new purchases can only go up. When stocks start to decline, they panic and sell. And the selling begets more selling. This makes the market vulnerable to a pullback.
Examples of excessive bullishness? Put buying (a bearish bet that stocks will decline) is minimal compared to call buying (a bullish bet). The Chicago Board Options Exchange equity put/call ratio is near the lowest level in 10 years. Next, consider my silver bullet sentiment indicator, the Investors Intelligence Bull/Bear Ratio. It just came in at 3.87. For perspective, anything above four is the warning path, by how I interpret this signal. Above five is a very clear signal that market weakness lies ahead. At least we are not there yet.
What does all this mean? Tobias Levkovich, Citi Research’s chief U.S. equity strategist, thinks the current level of bullish sentiment signals “a 100% probability of losing money in the coming 12 months” judging by historical patterns. “Indeed, we saw such levels back in early September, as well, right before a selloff in stocks,” he says. I was cautious ahead of the September pullback, too.
I’ve tracked insiders every day for 20 years. OK, that makes me a geek, but at least I have good feeling for the tone of insider buying and selling. I think this is better than quantitative measures that weigh selling against buying. Those are useful, but they have shortcomings. They include the activity of money managers who are not company insiders but still have to report activity because they have large positions. This muddies the water since the majority of money managers lag the market. Who cares what they do? I’m not that interested.
Other insider gauges try to “solve” this problem by eliminating all money managers. This is too blunt a tool, since it cuts out Warren Buffett and many money managers who actually are worth following. Indeed, as we see here, this approach missed the sell signal that I caught in late August ahead of the September sell off.
These two big-picture insider gauges also fail to capture which sectors insiders favor. That’s important. During March-June I was bullish on the markets and the economy because insiders heavily favored cyclical companies. Those outperform when the economy is improving. The insider preference for these names was a bullish economic signal for me, which many people missed. These two gauges also miss bullish insider patterns I look for, which amplify the insider signal.
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