The stock market is not even close to topping out, Thursday’s impressive rebound in the stock market is just what contrarian analysts were expecting. And they think more gains are in store.
That’s because sentiment conditions in recent weeks have been far different than what normally is seen at market tops. Not only did the bulls quickly retreat in the wake of that weakness, bullish sentiment was surprisingly subdued even before that weakness began.
Consider the average recommended equity exposure among a subset of Nasdaq-oriented market timers tracked by the Hulbert Financial Digest (as measured by the Hulbert Nasdaq Newsletter Sentiment Index, or HNNSI). Since the Nasdaq market responds especially quickly to changes in retail investors’ mood, and because those timers themselves are quick to shift their recommended exposure levels, the HNNSI is the most sensitive barometer of investor sentiment.
The HNNSI currently stands at 37.5%, which means the average Nasdaq-oriented market timer is allocating nearly two-thirds of his equity-versus-cash portfolio to cash. This current level is 25 percentage points lower than earlier this month, when the stock market rose to a new all-time high.
Current conditions are, therefore, far different than the excessive optimism that contrarians consider a hallmark of major tops in the equity market.
What I find even more noteworthy, however, is that the HNNSI never got higher than 62.5% during the market’s recent run to new highs. As you can see from the accompanying chart, this 62.5% is far lower than the levels to which the HNNSI rose earlier in the year. In March, it got as high as 93.8%, and prior to the July-August mini-correction, the HNNSI got up to 87.5%.
This is encouraging since the normal pattern is for bullishness to rise and fall more or less in lockstep with the overall market. That the HNNSI didn’t come anywhere close to a record high suggests there is a significant undercurrent of skepticism among market timers. And that’s bullish from a contrarian perspective.
Contrast the HNNSI’s recent behavior with what happened as the 2000-2002 bear market was beginning — at the top of the Internet bubble. Three weeks after the Nasdaq COMP, -0.78% hit a record high on March 10, 2000, the index was more than 18% lower — a decline that was almost big enough to satisfy the unofficial definition of a bear market.
And, yet, the HNNSI over those three weeks actually rose.
In other words, the typical Nasdaq-oriented market timer considered the drop a buying opportunity. That was most unusual, which is why contrarians were not surprised by the carnage that the Nasdaq subsequently suffered. By the end of 2000, the index was 52% below its March high.
As long as bullish sentiment continues to behave far differently than it did then, contrarians are likely to see market weakness as no more than a correction within an ongoing bull market.
