Where is the Bottom in this Nasty Decline?

Just how powerful is recency bias?

Well, the markets finally broke their record streak of days without a 5% or even a 3% pullback. Stocks rallied 40% since the presidential election, and last year the S&P 500 was up every month.

We’ve had a years’ worth of unflinchingly high indexes, which meant we had a year to convince ourselves this was the new normal. And so it’s unsurprising everyone is freaked out with a 3% decline, a fairly common occurrence in normal markets.

It really was easy to get lulled into complacency, and complacency is exactly what we have. Market sentiment indicators are at peak levels, and they have a long way to go to reflect the type of fear that marks market bottoms.

Let’s look at a few of these indictors and see where we’re at today.

First there’s the U.S. Advisors’ Sentiment Report, which has been around for decades. Last week, the level of bulls hit 66%. This represents the 16th consecutive reading where bulls clock in at over 60%, which is considered a danger zone.

That’s a constant level of over-bullishness while the market marched higher.

To put this in perspective, while the level of bulls dropped slightly from a high of 66.7% over the past couple of weeks, that high-water mark represents the highest level since April 1986! Investors are chasing the market higher and plowing their cash into equities as evidenced by record fund flows at the start of 2018.

Bears, on the other hand, are clearly still in hibernation. They sit at only 12.6%, which is also a record since April, 1986. With so many bulls and few bears, everyone is leaning in one direction. It’s the shift back to a more neutral stance that tends to hammer the markets over periods of time.

Next is the Ned Davis Crowd Sentiment Poll. Ned Davis Research is an institutional research firm with clients all over the globe. Its poll is a compilation of sentiment indicators. At 75.6, it’s well into the danger zone. And, while it backed off slightly last week, the prior high had been 75.7. That was 14 years ago!!

Lastly, we have the actions of individual investors.

Collectively, individuals are horrible at allocating capital during market extremes. The recent allocation to equities hit 71.2%. The all-time high is around 77%, right before the dot-com bubble burst and took the stock market with it.

Conversely, individual investors’ cash positions are just 13.3% now. That compares to an all-time low of around 11% in the late 1990s. Thus, for the most part, investors are fully loaded into the stock market and do not have a cash hoard from which to buy more equities if the market decline continues.

Whether this recent scare is “just” a scare or the start of something more, the stock market will eventually experience another bear market.

Given the extreme level of bullishness across advisors and individuals, the declines will probably be greater than normal. Once market sentiment shits too far into the bearish camp as equities get washed out, it could set up the buying opportunity of the decade.

Good investing,

John Del Vecchio
Editor, Hidden Profits

This post was originally published on Economy & Markets and can be seen here.