Growing Investor Optimism on Stock Market Continues to Raise Red Flags
We use investor sentiment as a contrarian signal on the direction of the stock market because historically investors have been wrong. The Red Flags caught our attention when bank of America this past week released a survey showing large investors have become 17% overweight on U.S. equities. That’s one of the most aggressive position in the last four years. However, we should note that there’s mixed results on drawing a firm conclusion from this survey. While the investors were very overweight, and therefore wrong, at the market peak just before the big market slide last fall, they also were equally overweight, and therefore right, on stocks at the 2016 market bottom.
So what will it be this time? For one thing, there was a major swing to overweight 17% since August. That means these big investors may have been lulled into a false sense of complacency. There’s also a longer-term warning sign for this survey. Since 2007 when these money managers were more than 15% overweight. The annualized return of SPY was -25.2% some 27% of the time.
What’s also worrisome is that the swing to overweight by the big guys comes at a time when other historically reliable contrarian sentiments indicators have trended to very optimistic. For instance, the Investors Intelligence survey of writers of investment newsletters shows bullish sentiment moved up to 53.8% from 50% the week before and 43.9% in late August. Bullish sentiment over 50% is a warning sign. It is over 55% calls for major defensive measures. Bears were down slightly to 17% from 17.9% the previous time and 18.7% the two weeks before that. More bearish signals from a contrarian viewpoint? The bulls/bear spread widened to 36.8% from 32.1%. This moved the indicator into the caution zone (see chart). In addition the percentage of these advisors predicting a correction moved to 29.2% from 32.1% the week before and 37.4% in late August. Anything below 30% is a warning sign.