Worst is yet to come

Commentator Mark Hulbert believes the market's decline has further to go based on four different sentiment measures. These measures include the Investors Intelligence weekly survey of newsletter sentiment, the American Association of Individual Investors sentiment survey, the sentiment index maintained by Hulbert Financial Digest and the CBOE's Volatility Index.

Mark Hulbert
June 25, 2013, 8:30 a.m. EDT
Market Watch

CHAPEL HILL, N.C. (MarketWatch) — Bad news: The bottom of the decline that began one month ago has not yet been seen.

That, at least, is the conclusion that emerges from a contrarian analysis of stock market sentiment. Simply put: Bullishness remains too prevalent.

To be sure, a few bulls have thrown in the towel in recent days. But most continue to believe that the bull market still lives. Many are not even conceding that we are in a full scale correction that takes 10% off the market averages — though Monday’s triple-digit decline will surely give them pause.

Reluctance to throw in the towel is a hallmark of market tops, according to contrarian analysis. In the wake of pullbacks that prove to be relatively shallow and short-lived, for example, advisers typically react with fear and panic, falling over themselves rushing for the exits. When a more significant market top has formed, in contrast, the typical adviser initially reacts with disbelief, stubbornly holding onto his bullishness.

I concluded that the market’s decline has further to go after placing recent sentiment developments in an historical perspective. I analyzed four different sentiment measures:

-The Investors Intelligence weekly survey of newsletter sentiment, data which extends back to 1963. Specifically, I focused on the ratio of bullish advisers in this survey to the total of those who are either bullish or bearish.

-The American Association of Individual Investors sentiment survey. As in the case of Investors Intelligence, I focused on the ratio of bullish responses in the AAII survey to the total of those who reported that they are either bullish or bearish.

-The sentiment index maintained by Hulbert Financial Digest (HFD). It represents the average recommended equity exposure among a subset of short-term stock market timers who are monitored by the HFD (as measured by the Hulbert Stock Newsletter Sentiment Index, or HSNSI).

-Finally, I focused on the CBOE’s Volatility Index VIX -9.20% , or VIX.

I analyzed how each of these four sentiment indicators behaved on the occasion of past bull market tops, using the precise definition of bull and bear markets employed by Ned Davis Research, the institutional research firm. That’s a comparison designed to make it look as though the bulls’ recent retreat was bigger than average, since the initial decline in bullishness following major tops typically is quite modest.

And, yet, I found that far fewer bulls over the last month threw in the towel than is the comparable average following past market tops. (Specifically, for each indicator and each market top, I measured the extent to which the bulls retreated over the first 34 calendar days of the decline. I chose 34 days since that’s how long it’s been since the bull market hit its high—at least according to the S&P 500.)

This is not a comparison that is encouraging for the bullish case.

Note carefully that contrarian analysis doesn’t predict how long a decline must last, or how much the market averages must decline. It instead focuses on whether there is enough fear and despair to rebuild the veritable Wall of Worry that bull markets like to climb. And it’s always possible that it a few more down days like Monday will do the trick.

But we’re not there yet. And there’s no need to speculate, since we can let the markets — and the erstwhile bulls — tell the story.

Also note carefully that some longer term indicators remain relatively bullish. The top-performing stock market timers tracked by the Hulbert Financial Digest, for example, remain — on balance — markedly more bullish than the worst market timers. My past research has found that this best-versus-worst contrast has a decent forecasting record over the intermediate term horizon of one year and longer.

Also relatively bullish right now are corporate insiders, as I wrote in a column late last week. Their greatest forecasting power also is over the 12-month horizon.

Nevertheless, if contrarian analysis is right, the market will decline over the short term before mounting a sustainable rally.

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