Stocks & Markets

Why Rising Bullishness Could Derail Stocks


Surveys and experts tracking investor sentiment suggest that, 13 months after stocks began a historic advance, the market's mood could be at a turning point from pessimism to optimism.

Yes, after a 79% jump in the S&P 500 index from its March 2009 low, investors may finally be starting to feel good about the stock market. Measures of investor sentiment tend to become more bullish well after a stock market rally has already begun, as large numbers of equity skeptics are gradually persuaded to become stock buyers when the market moves ever higher.

Stock pros are watching individual investors carefully for overconfidence, which could be a sign the rally is ending. Investors often feel the most bullish just before the market peaks, just as they feel most bearish just before stocks start a new rally.

"Historically, [market sentiment] is a contrary indicator," says John Gray, editor of Investors Intelligence, a service that tracks the sentiment of independent investment advisers.

A Majority of Bulls

On Apr. 21, Investors Intelligence's weekly survey of 130 investment newsletters showed the percentage of advisers bullish on the stock market rising 2.2 points, to 53.3%. Bears fell from 18.9% to 17.4%. The "danger zone for bullishness" is 55% to 60%, Gray says. "We're approaching that now."

A popular survey of individual investors, however, continues to show skepticism and bearishness. The latest American Association of Individual Investors' Sentiment survey, released Apr. 22, showed bullishness falling from 48.5% to 38.1% over the past week. That's barely above the survey's bearishness reading of 34.3%, up from 29.7% the previous week. The remaining respondents classified themselves as neutral.

Bruce Bittles, chief investment strategist at Robert W. Baird, sees a split between professionals—who recognize the strength of the economic recovery—and the general public, which remains pessimistic despite a 79% rise in the S&P 500 since the broad index's March 2009 low.

"We have optimism, but it's not the kind of excessive or extreme optimism you see" at a market top, Bittles says. That's a good sign for the rally, he says: "It's rare for markets to have these runs and investors remain skeptical."

What Fund Flows Show

Such surveys measure what investors and advisers are saying. Fund-flow data measure what investors are doing with their money.

According to TrimTabs Investment Research, investors have pulled $18 billion from U.S. equity mutual funds in the past 12 months, even as stocks kept pushing higher. At the same time, skittish investors put $403.1 billion into the relative safety of bond mutual funds, including $55.4 billion since the beginning of March.

The recent flow data for stock funds are more mixed. Investors pulled $5 billion from U.S. equity mutual funds in February, but $4 billion has trickled back into those funds since the beginning of March.

Michael Shinnick, a portfolio manager at Wasatch Advisors, says many retail investors, burned by the two bear markets in the past decade, are simply staying away from stocks entirely. With many baby boomers approaching retirement, "they're approaching the market with extreme caution," Shinnick says.

John Merrill, chief investment officer at Tanglewood Wealth Management, sees the same attitude among his clients. "The pessimism is pretty thick," he says. People are unhappy with politicians in Washington and angry at financial institutions that "stack the deck" against investors. "The sentiment out there is ugly," says Merrill.

Skepticism About Washington

Investing experts often cite the political climate as a reason for the lingering bearishness. Investors, who tend to be more conservative than the general public, don't like policies being developed by the Democrats in Congress and the White House, says Scott Armiger, portfolio manager at Christiana Bank & Trust. "We don't have business and Washington working together right now," he says. "Much of what is coming out of Washington is regulation."

Yet there are early signs that investors might be coming around, at least on the stock market. Investors have moved from stages of despair to disbelief over the past year, says Ryan Detrick, senior technical strategist at Schaeffer's Investment Research, which tracks sentiment closely. The next stage is "acceptance," he says. "It doesn't mean the bull market is over, [but] people are finally, slowly coming around to the fact that the economy without question is coming back strongly," Detrick says.

Merrill notices that his clients, while gloomy in mood, are spending more on themselves. "What they say may be one thing," he says. "What they do may be another."

The ETF Indicator

Investors in exchange-traded funds are a particularly good contrary indicator, at least according to a recent study by TrimTabs. ETFs are a favorite of retail investors and day traders, who tend to be "emotional and uninformed," says Vincent Deluard, TrimTabs' global equity strategist.

Deluard's study shows that above-average flows into ETFs have tended to occur before market declines and above-average flows out of ETFs happened before market rebounds. For ETF investors, "the market timing has been horrible for the last 10 years," Deluard says. One model portfolio, which bought the S&P 500 while the ETF investors sold, and vice versa, would have produced a 281% gain over the past 10 years.

Investors pulled $19.9 billion from ETF U.S. equity funds in January. Since the beginning of February, however, a net $12.8 billion has flowed back into those ETFs.

"We might be at a turning point," Deluard says.

If sentiment does improve significantly, it could be a sign the recovery is strong enough to outweigh investors' horrible memories from the past several years. Unfortunately, retail investors' better moods may arrive far too late, only after they have missed out on outsize stock market returns—and possibly just in time for a market pullback.

Steverman is a reporter for Bloomberg News in New York.

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