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Bull market still has room to run

Contrarian analysis points to further gains in the near term following the recent stockmarket turmoil

DON’T be too upset by the stock market’s recent decline. It may have been painful, but it’s probably just a stumble by a bull market that still has room to run.

That, at least, is the message that comes from contrarian analysis of investor sentiment – an approach to market timing that relies on the propensity of the average investor to get the market’s near-term direction dead wrong most of the time.

When stocks are really about to decline, for example, and the profitable course of action would be to sell some of the stock in a portfolio and hold cash, the typical investor tends to remain stubbornly optimistic, treating the decline as a buying opportunity.

On the other hand, when the stock market is experiencing a mere correction, and the optimal response would be to load up on stocks, investors generally believe that the decline is just the beginning of something far worse.

It is difficult to measure the sentiment of all investors accurately, so practitioners of contrarian analysis often focus on the opinions of a group of people whose views are broadly representative of investors as a whole, and whose moods are easily quantified.

Investment newsletter editors meet these conditions nicely. Research conducted by the Hulbert Financial Digest over the last two decades shows that the stock market generally has fallen when newsletter editors have jumped on the bullish bandwagon, and the market has risen when the newsletters have been most bleak.

Investment newsletters have been quite gloomy lately, reacting to stock market weakness by hastily moving to cash. From a contrarian point of view, this is a strong bullish indicator. It certainly does not fit the model of what has typically happened before the onset of a bear market. In those episodes, newsletters have typically been bullish.

Consider the average recommended exposure to the stock market among the short-term market timing newsletters tracked by the Hulbert Financial Digest. By Monday, that average had fallen by 63 percentage points since the Standard & Poor’s 500-stock index hit its high in early October, from 50 per cent then to minus 13 per cent early this week.

This meant that the editor of the average short-term market timing newsletter was recommending that his clients allocate 13 per cent of their equity portfolios to actually shorting the stock market – an aggressive bet that the market will go down. By Thursday’s close, that average had climbed back into slightly positive territory at 8 percent. Even with that bounce, however, the average newsletter was extremely pessimistic.

To put the newsletters’ retreat into an historical perspective, consider how they reacted in the weeks after the S&P 500 hit its top in March 2000. At the time, of course, no one could have known for sure that the Internet bubble was bursting and that the decline beginning that month would last for more than two-and-a-half years and lead to a halving in the average share price.

What is clear is that the short-term market-timing newsletters, on average, were not particularly concerned about the prospects for the market. They did not use that decline to reduce the recommended equity exposure of their portfolios. On the contrary, they considered it a buying opportunity. During the first three months after that market top, the newsletters actually increased their average recommended exposure to stocks.

In contrast to the happy-go-lucky attitude that prevailed then, the majority of newsletter editors this time around have fallen over themselves to jump off the bullish bandwagon. Their behaviour bodes well for the stock market’s near-term direction, since in the past they have regularly got it wrong. To bet that stocks are about to enter a bear market, you would need to bet that these Wrong-Way Corrigans will get it right this time. Based on past performance, that’s not very likely.

It is worth noting that contrarian analysis is helpful only for timing the markets’ shorter-term gyrations. Over periods of one year or longer, for example, it sheds little light.

In suggesting that the final top of the recent bull market has not yet been reached, therefore, contrarian analysis does not hazard a guess as to when that top will arrive or how much higher the stock market will be then compared with today. But it does suggest that stocks’ path of least resistance over the next few months will be up.

Contrarians are fond of saying that bull markets like to climb a wall of worry. It would appear that for now, that wall is very much intact.

Mark Hulbert is editor of The Hulbert Financial Digest, a service of MarketWatch

 

Source: NYT (Business Times 5 Dec 07)

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