Why Now's the Time to Fear the Next Crash


When most investors are fearful, it pays to get greedy. But even if you can follow through on that advice, what many people forget is the converse: When you find greed throughout the stock market, it's time to start pulling back and wondering what the next shoe to drop might be.

Investor sentiment has long been an indicator that smart market players bet against. Now, one clear measure of where we are on the fear-greed spectrum shows regular investors as optimistic about stocks as they've been since before the March 2009 market bottom -- and the result could be devastating.

Short interest and you
Even among sophisticated investors, selling stocks short isn't a run-of-the-mill strategy everyone uses. In order to use it, you have to get clearance from your broker, along with the margin capacity to sustain your short trades. More important, you have to be willing to accept the theoretically unlimited losses that shorting entails, accepting instead the maximum 100% gain you could earn if the shares you short drop to zero.

But when you add up all the short-selling activity in the market, you get an interesting barometer on the general attitude toward stocks. And according to findings from Strategas Research Partners, the level of short interest on the New York Stock Exchange is currently nearing its lowest levels in the past three years -- suggesting that most investors believe there's no money to be made by betting against a bull market.

Get ready
You can see the same trend in certain stocks that got beaten down last year. AuRico Gold (NYS: AUQ) got slammed in 2011 despite pulling off a favorable buyout of Northgate Minerals, as a year-end drop in gold prices seemingly spooked the investing community. But just in the last two weeks of December, short interest dropped a whopping 7.2 million shares, a 62% drop that corresponds rather closely to the short-term bottom for the gold stock. Shares have climbed almost 8% since the beginning of the year.

Corning (NYS: GLW) has seen a similar change in sentiment, with short interest down by almost half to 18.1 million shares. Perhaps in response, the stock is up 9% so far this year even though the fundamentals behind the company -- strong touchscreen demand in smartphones and tablets largely overshadowing moderate weakness in TV sales -- haven't changed all that much recently.

Elsewhere in tech, JDS Uniphase (NAS: JDSU) has seen a similar reversal of short-selling fortune. Shares of the networking company are up 13% in 2012 while short interest has plunged by 4.7 million shares, or 44%. With mobile and cloud computing continuing to push demand higher, it's reasonable for investors to be hopeful about the company.

Look out below?
But the problem with the disappearance of short-sellers is that bulls have already used up any catalyst that short-covering activity would generate. In other words, if the companies can't now deliver on the promises they've made, then a relative lack of short interest will require bears to take on new positions, thereby pushing prices down further.

Of course, short interest isn't a perfect contrary indicator by a long shot. Travelzoo (NAS: TZOO) has remained near the top of the short lists by percentage of float for six months or so, and although the stock is more than 40% higher than its lows, it's also down 70% from its levels just from last April. Similarly, SodaStream (NAS: SODA) has had high short interest since June, and while it has bounced back from disappointing earnings by having what appears to have been a solid holiday season, the shares still fetch only half of their 52-week high value.

Be prepared
Short-term indicators are notoriously imprecise, and a bearish contrary indicator doesn't tell you exactly when a correction may come. What's clear, though, is that sentiment has grown a lot more favorable toward stocks lately. If you can't afford to suffer through another market drop, now's the time to look at whether the risk level of your portfolio matches up with your temperament.

Even if stocks drop in the short run, you can't afford to give up on your long-term investing strategy. The latest special report from the Motley Fool will keep you on the straight and narrow. Inside, you'll find revealed three stocks to help you retire rich. It's free but only available for a limited time, so click here and read it today.

At the time thisarticle was published Fool contributor Dan Caplinger always has a little fear, but he uses it well. You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Corning. Motley Fool newsletter services have recommended buying shares of Corning, Travelzoo, and SodaStream International. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy shorts no one.

Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.