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BEING STREET SMART

by Sy Harding 

Let's Not Get Too Optimistic!

January 27, 2012.

In investing much is said about the folly of following the crowd.

It’s voiced in age-old maxims like “The market will do whatever it must to fool the majority”, and Warren Buffett’s advice to “Be fearful when others are greedy, and greedy when others are fearful”.

It’s measureable in investor sentiment statistics, which clearly show that investors tend to be overly fearful and pessimistic at market lows, not willing to participate when the market turns up, and then overly bullish and confident at market tops, not believing a rally has ended.

The current rally has been underway since October 4^th. The S&P 500 has gained 21% in the four months since, which would be an impressive gain for a full year. Is it getting a bit ahead of itself?

Investors are finally catching the fever. This week’s poll of its members by the American Association of Individual Investors shows 48.4% are bullish and only 18.9% bearish. Those aren’t extreme readings, but are clearly opposite to the sentiment in late September, just before the rally began, when it was the bearish percentage that was at 48% and the bullish percentage at only 25.3%.

The VIX Index, also known as the ‘Fear Index’, measures the sentiment of options players, another meaningful method of measuring sentiment. It was at 42.9, historically a high level of fear by this measurement, in late September at the market low. Fear has declined significantly as the rally off the October low has progressed, with the VIX Index now at just 18.6, in the zone of low levels of fear, high levels of optimism, usually seen at rally tops.

So, is it time to take profits from the rally, or even take downside positions in anticipation of a correction?

In that regard, I like another of Warren Buffett’s insights regarding not following the crowd, “You are neither right nor wrong just because the crowd disagrees with you. You are right because your data and reasoning are right.”

In other words, plan to sell when others are greedy, but investor sentiment alone cannot be used to tell you greed and optimism are so high that a top is due. Sentiment can only be used as an indication that ‘the crowd’ is becoming bullish or bearish enough that it’s time to keep a close watch on other data and indicators.

When I look at other data and indicators my work includes a considerable amount of technical analysis. That is, whether a market is potentially overbought or oversold, is near potential support or resistance levels, whether money flow into or out of the market has reversed, and so on.

So, while investor sentiment reached overly bearish levels last September, my other indicators did not trigger their buy signal until mid-October. Shortly thereafter changes also seemed to take place in the fundamental conditions, most notably increasing signs that the U.S. economic slowdown of the first half had bottomed and the recovery from the ‘Great Recession’ of 2007-2009 had resumed.

And now, with investor sentiment recovered and reaching toward being overly optimistic, is it time to consider the potential for at least a pause in the rally?

We can look at another troubling condition. The enthusiastic buying in January has the market again spiked up into a potential short-term overbought condition above 50-day moving averages, to a degree that often brings a decline back down at least to the m.a. That would be a decline of 5 or 6% - if it halted at the moving average.

Then there is the history of February often being a negative month.

My intermediate-term technical indicators remain on their October buy signal, and the market’s favorable seasonality does not usually end until April or May.

But the high level of investor bullishness, and short-term overbought technical condition, indicate it may be time to temporarily take some profits from the rally.

That does not change my overall outlook for the year. If a short-term correction does develop it will be accompanied by gloom and doom predictions of something worse. But my work tells me the rally would likely resume to new highs by the end of the market’s traditional favorable season in April or May. Only then am I expecting a more serious sell-off, sometime in the unfavorable summer months, from which profits can again be made from downside positions.

But anything can happen, and in the interest of risk management, for now it’s probably at least a time for caution, on the potential for a pullback at least sufficient to cool investor sentiment off to some degree.

Sy Harding is president of Asset Management Research Corp, and editor of www.StreetSmartReport.com, and the free market blog, www.streetsmartpost.com.

These reports reflect our opinions and are based on our best judgment, but no warranty is given or implied as to their accuracy. Past performance does not guarantee future performance.

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