Investor optimism not flashing a danger sign

One long-time lesson of investing is that too much optimism is a bad thing. So you’ll know that the stock market’s recent powerful rally is close to its end when bullishness on Wall Street reaches an extreme—“irrational exuberance,” to use the famous phrase from Nobel Laureate and Yale University professor Robert Shiller.

Fortunately, we’re not there yet, even as the Dow Jones industrial average is back above the 18,000 level for the first time since last summer, and the Dow and Standard & Poor's 500 index are closing in on their record highs set last May.

The notion that too much optimism is a bad thing comes from an investment theory known as contrarian analysis. Many trace it to the late Humphrey Neill, a Vermont-based investment adviser from a century ago, one of whose books was The Art of Contrary Thinking. Perhaps the most famous line from that book is: “When everyone thinks alike, everyone is likely to be wrong.”

Though you might be inclined to dismiss contrarian analysis as little more than voodoo, it actually makes sense. When bullish enthusiasm reaches an extreme, little sideline cash remains that could otherwise be quickly invested and thereby propel the market even higher. By the same token, at times of extreme pessimism few skittish investors remain who haven’t already exited the market and gone to cash. That means there’s little potential selling pressure that could cause the market to sink even further.

To appreciate how subdued stock market optimism is right now, consider the average recommended stock market exposure among several dozen short-term market timers I monitor (as measured by the Hulbert Stock Newsletter Sentiment Index, or HSNSI). This average currently stands at 47%, which means that over half of the typical market timer’s stock market portfolio is in cash. That’s amazing, considering that the Dow is only 1.2% away from climbing to a new all-time high.

The mood then was far more update than it is today: The HSNSI that month got as high as 73%, which was one of the highest readings of the last two decades—and 25 percentage points higher than today’s level. Contrarians last summer were therefore not surprised by the market’s subsequent stumbles.

At the stock market’s low early this past February, in contrast, the HSNSI fell to minus 31.4%. That negative reading meant that the average short-term market timer was actually net short the market—an aggressive bet that stocks would continue to decline. Sure enough, the market rallied in the wake of that extreme pessimism.

To be sure, with today’s HSNSI level considerably higher than at the February low, sentiment conditions today aren’t nearly as favorable as they were at the bottom. But they still fall short of excessive optimism, according to Hayes Martin, President of Market Extremes, a contrarian-oriented investment consulting firm that focuses on major market turning points.

In an interview, he characterized recent sentiment changes as moving “from deep pessimism to skepticism to moderate optimism and surprise.” So long as the prevailing mood remains at current levels and doesn’t approach the extremes seen in May 2015 at the market's high, he continued, the rally could very well “go on for longer than generally expected.”

Bear in mind that sentiment conditions can change quickly, especially in today’s fast-paced market. So by no means do current favorable sentiment conditions guarantee that the market will continue rising indefinitely.

The ideal scenario, from a contrarian perspective, would be for bullishness to remain at relatively restrained levels even as the stock market rises to new highs. In contrast, the rally would be skating on thin ice if stock market timers were to quickly jump onto the bullish bandwagon.

For now, though, the mood on Wall Street is surprisingly subdued, which—according to the logic of contrarian analysis—is a good thing.

Mark Hulbert, founder of the Hulbert Financial Digest, has been tracking investment advisers' performances for four decades. For more information, email him at mark@hulbertratings.com or go to www.hulbertratings.com .