Could Bullish Investor Sentiment Signal a Coming Bear Market?

Are stocks set to rally into 2011 and beyond? The many financial analysts who see investors are rotating out of safe-haven bonds into riskier stocks seem to think so. But before leaping into equities at this juncture, investors would be wise to check sentiment readings, which often signal reversals when they reach extremes.

For instance, investor sentiment was very bearish on Aug. 31, the very day before an explosive rally ignited on Sept. 1. As I reported last month, sentiment has swung high -- and it's climbed still higher in recent weeks, as these charts from Market Harmonics illustrate.

Drawn from Investors Intelligence data, the first chart shows that the percentage of bulls now exceed the peak that marked the precise top of the 2010 rally in early May. From that peak, stocks swooned more than 10% in the next few months.

In the last three and a half years, the only higher peak occurred in late 2007. That data point alone should give bulls pause.

Another way to identify likely reversal points is to look for extremes in the bull-bear sentiment chart. Market tops are easily identified by the times that bullish sentiment peaks at the same time that bearish sentiment plummets. We can easily see three such points: November 2007, during the multiyear market peak; May 2010, the year's previous top; and now.

Conversely, the best time to buy was when bearish sentiment spiked and bullish sentiment dropped. When bearish readings hit 40% or higher and bullish readings slide to 30% or lower, that's a fairly reliable signal that the market has reached a near-term low. And that's what we see in late August, just before the powerful rally began. The less extreme crossover in July offered a "buy" signal as well.

What is Mr. VIX saying?

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Another common measure of investor sentiment is the VIX, the so-called "fear indicator" that reflects investors' mood by charting the number of protective put options (which give investors the option to sell shares at a specific price within a certain time frame) and bullish call options (which gives investors the option to buy shares at a specific price within a certain time frame) that investors are buying.

When the VIXS drops, it means investors are feeling complacent about protecting their positions with put options, and when VIXS rises, it means investors are feeling anxious and buying more puts to protect their portfolios against sharp declines.

The VIX has been tracing out a worrisome "megaphone" pattern since October, named for its cone-shape. Why is this worrisome? By hitting sequentially higher highs and lower lows, one following the other, the VIX is reflecting increasing uncertainty and volatility. Investors' moods are swinging from euphoric bullishness and a few days later to intense fear.

This suggests that market participants don't have much conviction about the rally, because every few weeks they nervously drive the VIX up to a level that surpasses the last spasm of fear.

In July, the VIX reached a high that marked the market's low point. The VIX climbed up again in late August, then finally settled into a steady downtrend as the powerful rally that started Sept. 1 gathered steam. One sign of a strongly rising market is a steady decline in the VIX, which is what happened from Sept. 1 to the second week of October.

Since then, the VIX has been signaling greater unease, even as stocks have lofted higher. This divergence, and the megaphone pattern in the VIX, leaves technical analysts less than confident in the rally's staying power.

Turning to a chart of the Dow Jones Industrial Average, we see this same waning of bullish enthusiasm in the declining relative strength indicator. A trading range of 11,000 to 11,400 has remained firmly in place for the last two months. For the bull to move up from here, the market must decisively break through the 11,400 threshold.

As we can see on the chart, the Dow has a pattern of wobbling indecisively for 5 to 7 days in a narrow range before making a dramatic move up or down. We are currently tracing out just such an extended period of narrowing range. Some technicians see these periods as equivalent to compressing a spring: When the market finally leaps out of the range, it does so energetically.

A strong jump would confirm the bull is alive and well. A drop back to the 11,000 area would signal the market needs another span of consolidation.

Interestingly, the S&P 500 is also poised at a critical resistance level: the 61.8% retrace of the entire move from the late 2007 peak to the March 2009 low. Technicians have long noted that the Fibonacci levels (38.2%, 50% and 61.8% respectively, of any measured move from a peak to a trough) often provide support or resistance, and the 1,235 level marks the precise line that the SPX has touched -- but hasn't been able to decisively exceed.

Earlier this week, both the Dow and the S&P 500 hit their highest levels since September 2008, while the NASDAQ surpassed 2,616, its highest close since Dec. 31, 2007. Until the markets can bulldoze their way higher through these key resistance levels, then caution is warranted.

And as for the theory that participants are rotating money out of bonds into stocks, that seems to contradict the fact that domestic investors have been pulling money out of stock mutual funds for 31 straight weeks.

Even if some investors are dumping bonds in favor of stocks, experienced market watchers will be keeping their eye on the extreme highs in investor sentiment, as these have reliably marked market tops in the past.