Violence in the streets of Libya on Feb. 22 seemed to do something that all the previous Mideast upheaval couldn't accomplish: throw the brakes on U.S. stocks. The Standard & Poor's 500 index finished the day 2.05 percent lower, at 1,315.44. But what worries many technically oriented analysts more than the threat to oil markets or shaky regimes are the relentlessly positive attitudes of investors.
Those technical analysts, who study stock price and trading volume patterns, view positive investor sentiment as a contrarian indicator. The American Association of Individual Investors' sentiment survey for the week ended Feb. 16 showed 46.6 percent of respondents—who are do-it-yourself investors and AAII members—were bullish about the next six months, vs. 25.6 percent bearish and 27.9 percent neutral. Other closely followed surveys such as those done by The Hulbert Financial Digest and Investors Intelligence also show bullish sentiment at elevated levels.
"When everyone's bullish, you should beware," says Rick Cortez, senior portfolio strategist at Broadmark Asset Management, the sub-adviser for the Forward Tactical Growth Fund (FTAGX). "Some of these measures are as high as they were at the [October] 2007 top."
That doesn't mean that Cortez is ready to call a halt to the 21-month-long U.S. bull market. In fact, several technical analysts still expect it could be a while before the ultimate market top arrives.
Scott O'Neil, president of MarketSmith, a growth-oriented investment management firm in Chicago, admits to being slightly surprised by how strong the market has been, but says: "When it's this strong and broad, it should carry on further." And since historically market tops have most often come in January and April, he says that if the current bullish sentiment continues to build, the rally could extend beyond April. But to get more comfortable with what's happening, you need to drill down into individual sectors to see where the strength is coming from. He sees technology, industrials such as Caterpillar (CAT), and fertilizer manufacturers as particularly robust right now.
Historically, long-running bull markets have turned downward because the Federal Reserve Board acts to rein in the money supply to combat inflation, notes Cortez. The second phase of the Fed's "quantitative easing" program is slated to end in June. Provided the market's upward momentum isn't broken in the next couple of months, Cortez expects investors and strategists to begin carefully studying what's fueling stocks starting in May; that reassessment could result in more pronounced slowing. Since the market top of October 2007 was preceded by 17 interest rate hikes between June 2004 and June 2006 (and back-to-back decreases totaling 75 basis points in September and October 2007), he doubts that the first couple of times the Fed raises either the federal funds rate or the discount rate would be enough to signal a top, though those hikes would be leading indicators. The yield on the 10-year Treasury bond climbing above 4 percent (it's currently 3.59 percent) would be another leading indicator of a market top, he says.
Another red flag would be stock prices rising without corresponding increases in trading volume or market breadth, Cortez says. All prior market tops have been characterized by major indexes climbing to new highs while the cumulative line representing all individual stock advances minus declines has failed to keep pace with price gains, with trading volume also lagging price gains. "We're not seeing that at all now," he says.
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