Growing Investor Optimism Could Signal a Bear Market Ahead

Investor sentiment readings are by their nature less precise measurements than the stock prices or price-earnings ratios, but extremes in sentiment have an uncanny correlation with tops and bottoms in the stock market.

Investor sentiment is a classic, and remarkably accurate, contrarian indicator. When investors become exuberantly bullish, its a sign of a market high. When they are excessively bearish, that aligns with market lows.

The explanation of this correlation runs something like this: By the time the majority has become bullish, they've already bought into the market, and there is nobody left to buy in and push prices higher. Conversely, once the majority has become bearish, there is nobody left to sell and drive prices lower.

Market watchers have recently noted that by some measures investor sentiment has reached bullish levels not seen since early 2007.

This observation is at odds with measures of insider selling: By some accounts, insiders are selling 3,177 shares for each one they purchase. That statistic is not bullish, as insiders are presumed to have the most comprehensive view of their companies' near-term prospects.

Trends in Bullish and Bearish Sentiment

To peek under the hood of investor sentiment, let's look at three charts: the Investors Intelligence percentage of bulls, the percentage of bears, and a five-year chart of the S&P 500 ($INX) which will enable us to align price peaks and valleys with the highs and lows of investor sentiment.

The percentage of bulls chart shows that it peaked in October 2007. From there, sentiment traced out a classic downtrend: lower highs, and lower lows. This movement in bullish sentiment was, in hindsight, a clear warning that the faith holding up the market was waning.

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Unsurprisingly, bullish ardor hit bottom in October 2008 as the global financial crisis crushed global stock markets.

In January 2009, bullish "animal spirits" spiked -- in hindsight, a clear signal that the bottom in stocks was close at hand. Though the final bottom in price did not occur until early March, the rise in bullish sentiment in January was a significant sign of trend reversal.

The uptrend in bullish sentiment continued tracing higher highs and higher lows until May 2010, when it peaked -- not coincidentally, just before the European debt crisis sank global stock markets.

Since then, the bullish sentiment bottomed in August, and has since risen to a new peak. But tellingly, this peak is lower than the previous high in May -- evidence that bullish attitudes are in a new downtrend.

If we compare the uptrends in bullish sentiment with actual price action in the S&P 500, we see they align rather smartly: sentiment hit bottom in the first quarter of 2009, as did the market, and it hit a high in May 2010 as did stocks.

Turning to the percentage of bears chart, we see bearish sentiment peaked during October 2008, when the global financial crisis pancaked stocks. From that peak, bearish spirits declined to a low in January 2010.

Though the stock market continued rising until May, bearish sentiment was also carving out a new uptrend, similar to the uptrend in bearish mood in 2007 that presaged the eventual 40% decline in stocks. In other words, peaks in bearish sentiment are setting new highs.

Bullish sentiment is waning, and bearish sentiment is rising: This is precise set of trends which occurred in late 2008 just before the stock market reversed course and fell precipitously.

While investor sentiment readings don't "ring a bell" at the precise top or bottom, history suggests they are uncannily accurate in calling board tops and bottoms. If this previous correlations are accurate this time, then sentiment readings are flashing unmistakable warnings that the market may be ripe for reversal.