Investor sentiment is now quite elevated. That makes the stock market particularly vulnerable in the “contrarian” sense.
Contrarian investing holds that it pays to do the opposite of the crowd because the crowd is often wrong. Also, consider that when almost everyone is bullish, there are fewer people on the sidelines to turn bullish and buy stocks to push yours higher. That’s the state we are in now.
Meanwhile, insiders are bearish.
This is not a good combination for longs.
Here’s a closer look at these two indicators, and what to do about the pullback risk.
[text_ad]
Elevated Sentiment
The Investors Intelligence Bull/Bear ratio printed 3.87 last week. This is remarkably high. The ratio is in rarified territory where it historically does not spend a lot of time (the 3.5 to 4 range). In fact, just yesterday, the ratio reached 3.99, an even more cautionary sign, as sentiment has lifted even higher. It normally retreats out of these levels at some point and often fairly quickly – though elevated bullishness can persist. What makes the ratio come down is a decline in stocks caused by some negative event or surprise. It doesn’t really matter what the event is.
But two top candidates right now include “surprises” on the economic front and some geopolitical event.
On the economic front, GDP growth is actually remarkably low right now, at around 2% for the third quarter if you take out the artificial impact that imports have on the GDP calculation. Many investors are unaware of this. So, they will be surprised when more evidence of economic weakness emerges. This could spark selling.
Here’s how imports are artificially boosting the GDP measure: Imports surged in the second quarter as companies stocked up ahead of tariffs. This suppressed the GDP measure – since trade deficits are subtracted from GDP. Then imports normalized in Q3, falling sharply. This artificially boosted the Q3 GDP read relative to Q2. Take out the import noise, and Q3 growth was really around 2%. That used to be called “stall speed.”
Investors looking at the headline Q3 GDP growth of 4.4% think growth is strong. They will be “surprised” when more evidence of stall speed growth emerges. Mediocre economic growth news could spark selling.
I don’t think we get a recession this year, in part because productivity is so strong. Higher productivity means companies are getting more output per worker, typically because companies have invested in equipment and technology that makes workers more efficient (not because they are working harder). Productivity gains boost margins and earnings. This helps support growth.
Ed Yardeni of Yardeni Research puts the odds of recession in the low 20% range. Since we are unlikely to see a recession, we are unlikely to see a severe bear market 20%+ correction. That’s because recessions are normally what cause bear markets. But a pullback to trim investor enthusiasm and normalize sentiment levels might be in order.
On the geopolitical front, the potential risks are obvious to anyone who follows the headlines. I don’t need to outline them here.
Bearish Insiders
While investors are extremely bullish, insiders are cautious. Though insider activity is lighter now because of earnings season lockdowns on their trading, we can still get a read by comparing the overall buying volume to selling volume for insider trading that is allowed. Insider buying has dried up relative to selling, which tells us insiders have turned bearish.
The bottom line: Insider caution plus investor bullishness is not a good combination.
The Action Plan
What should you do with this information?
I would not suggest selling out everything here to try to avoid a pullback that might not happen. Nobody can predict pullbacks, least of all me. I can only identify when markets are meaningfully vulnerable because sentiment is near an extreme high. That is the case now.
Instead of selling and moving to cash, it makes sense to be cautious here about putting on new positions. Also, consider taking any trading profits more quickly. Trim or limit the use of margin. Have buying power. I would not sell out of longer-term multi-year positions.
Next, when significant pullbacks happen, I typically suggest shorting the Chicago Board Options Exchange’s CBOE Volatility Index, or the VIX. Consider this tactic if you see the VIX spike, which normally happens during a market pullback. The vehicle for shorting the VIX and getting exposure to this reversion to the mean play is the -1x Short VIX Futures exchange-traded fund (SVIX).
[author_ad]
