Excessive Bearishness - Here's How to Play It

I took a poll in one of my recent webinars asking how many people use sentiment indicators, and more than half said they did NOT!!

Words can’t describe how surprised I was, as these are some of the most important indicators an investor can use. 

Too much bearishness is bullish -- but there is one important caveat.

This caveat is often forgotten by investors, and BOY does it cost them.

I can’t stress enough the importance of not just jumping into bullish positions based only on the fact that too many investors are bearish. 

I can remember like it was yesterday, growing up on Wall Street, one of the first things I learned from my elders:  “Never catch a falling dagger.”

Being a contrary investor is one style of investing or trading, but there are many ways to go about contrary investing. 

The idea is this:  When it seems like everyone is betting on the same direction for the price of any security, sector or market (betting the current direction will continue), it’s very likely that the direction will soon change.  

The reasoning for that thinking is as follows: 

1. Most of the money that is to be invested to profit from that direction has likely already been deployed, leaving very little money to cause that trend to continue.  If nobody has money to push stocks higher (in an uptrend) or lower (in a down trend) then the trend should soon stall.
    
2. Once some investors want to exit their positions, they will place a trade in the opposite direction. 
   
   If the trend has been down, then investors who've been bearish would exit the bearish trade by repurchasing the security (stock, etc.).  If the trend has been up, then investors would have to sell in order to exit the position. 
   
   But because so many investors had bet on the same direction, exhausting their capital (for example, bullish investors who had been buying have no more money to buy more stock), they have no more money to make the same bet (buy).  So when one big investor decides to start selling, the price can come crashing down, as no big investors are there to buy (support the price of) that stock.
   
   The above example describes an overly BULLISH situation, but the opposite is true with an overly bearish situation -- like we have today.

The chart above shows the S&P 500 (upper) and the results of a poll (below) taken by Investors Intelligence on the stock market outlook of investment advisors and newsletter publishers (not affiliated with brokerage firms or funds).  The red line shows the percentage of bullish advisors and the blue line shows the percentage of bearish advisors. 

Obviously, when the two lines contract (the percent of bulls is declining and the percent of bears is increasing) it shows increasing bearish sentiment. 

Another way to look at the same data is to chart the difference between the two lines.  The current difference is 7.4 percentage points. 

When the difference is less than 10 percentage points, sentiment is considered to be overly bearish.


Many contrarian investors mistakenly stop here.  They decide that since we have a “crowded trade,” the trend must be nearing its end.  And in many cases, they are correct.  But when they aren’t correct (which is not a rare occurrence) it’s extremely painful!

It’s best to wait until you get a “BUY SIGNAL” from this indicator before jumping in to BUY stocks.  Just like every indicator, this indicator can generate “false signals,” or signals that don’t pan out. 

Instead of getting bullish (buying) when sentiment is overly bearish, it makes sense to wait until (after being overly bearish) you see the sentiment indicator changing direction. 

It’s a weekly indicator published on Wednesdays.  I am the guest on “Morning GPS” Wednesday mornings.  So tomorrow morning, and every Wednesday morning, I will update you on this indicator. 

It’s below the key 10-percentage point difference level.  If it advances, generating a buy signal, that will be one leading indication that we are at or very close to a stock market bottom. 

If you aren’t a Morning GPS listener, you should be.  You can sign up by entering your email address after visiting this link.  

I hope you'll listen in going forward, particularly over the coming weeks, as I'll be sure to keep you in the loop on this critical indicator.

Chris Rowe
Chief Investment Officer
Technical Analysis Millionaire