Key Sentiment Indicator Flashes Danger Warning

November 6, 2013

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The stock market's impressive summer rally has left investors with nice profits and a smile on their faces. But it's also made them too optimistic.

That was the message from Investors Intelligence, which each Wednesday releases its analysis of the prognostications of more than 100 stock market newsletter writers. This week's report showed 55.2% of them were bullish and only 15.6% were bearish.

That's an extreme of optimism — and extremely worrisome. The weekly compilation of bulls and bears is a contrary indicator. Since 1963, Investors Intelligence has shown that when the majority of gurus were bullish, the market was near a peak. And when the majority was bearish, the market was likely near a bottom.

The reason is simple, but counterintuitive: When investors get overconfident, available money is in the market. Who's left to invest? When the majority is bearish, vast sums are on the sidelines. A few investors who sense a bottom can start a stampede of bulls.

It's not just newsletter writers and their followers. It's professionals, too. As money flows into mutual funds, it must be put it to work buying stocks. A hedge fund or mutual fund that becomes too defensive may find itself outperformed by competitors. Hence, the pressure to run with the herd.

It's part of the market's perverse aptitude for instilling humility and punishing the arrogant and complacent. The Investor's Intelligence poll results are published daily with a chart of recent changes on IBD's Psychological Markets Indicators page. Sentiment indexes such as the Investors Intelligence poll are secondary indicators. While they are helpful guideposts, investors should be primarily guided by the action of price and volume of the major indexes and by leading stocks.

The 55.2% number equals the high for the year, set the week ending May 24, just as the S&P 500 hit a minor top and corrected 8%.

The last time the percentage was larger was the week of April 8,2011, when it hit 55.4%. Within a month, the S&P 500 began a 22% correction.

Another way to analyze the data is to look at the spread between the bulls and bears. Today's spread was 39.6. The last time it was higher was April 8, 2011, when it hit 41.6.

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