I have read several articles as of late dicussing the excessive bearishness of investors, which from a contrarian point of view, is bullish for the stock market. The general position is that investors are so bearish that they are now just hiding in bonds and stuffing cash into their mattresses, and let’s not forget stocking up on gold and ammo, and shunning stocks completely. However, is that the case? With the majority of analysts still predicting S&P 500 operating earnings to surge by almost 15% in 2013 hitting $115 per share it is difficult to pin that as bearish. Furthermore, the same analysts have year-end S&P 500 price targets ranging from 1450-1500 with some estimates as high as 1600. No bearishness here either. So where is it?

Maybe it is the individual investor? If we look at money flows, according to the latest data from ICI, we can definitely make the case that individual investors are more bearish than bullish. As shown in the chart during the entire advance from the May lows investors have been steadily liquidating equity mutual funds and buying bond funds.

This data set does confirm that investor sentiment is currently more bearish than bullish. It also shows us that investors, on average, are doing exactly the opposite of what they should be doing – buying into markets near tops and selling at bottoms. Investors are today, more than ever, responding to the lesson’s learned after twelve years of a secular bear market – safety of principal, and income generation, trumps speculative market risk. However, over the last month equity inflows have turned up as individuals “fear they are missing out” on the current market advance. This is more indicative that we may be approaching a near term market peak rather than a buying opportunity. From an investment standpoint, however, this particular data set, while elightening in regards to investor behavior, is more of a lagging indicator.

If we really want to know what investors are thinking on a “real time” basis then we need to look at indicators that reflect investor sentiment within the markets currently. For this type of analysis we can look at market indicators of investor sentiment such as the Volatility Index, AAII Bullish and Bearish sentiment, Market Vane Bullish and Bearish Sentiment, Rate of Change of the S&P 500, and New Highs vs New Lows on the NYSE. While each one of these can give us an indication of current sentiment on their own – I have compiled them into a single index so that we may get a more comprehensive picture of overall bullishness or bearishness in the market.

The chart shows the S&P 500 overlaid with the composite sentiment index which effectively is a measure of the perceived“risk” in the market. The index remains above the zero line when markets are rising and sentiment is bullish and vice versa. One thing to note is that during cyclical bull market advances the ratio moves into a declining trend. As investors become fully allocated to the market demand wanes as the inflows of net new money declines. Therefore, each advance in the market takes the risk ratio to a slightly lower peak but with each decline being a buying opportunity when the index slips into mildly negative territory. This is why during cyclical bull market advances the average investor does well “buying dips.”

Currently, the risk ratio is pushing back up to the April highs. It is fairly safe to conclude that the market is not pessimistic – but actually quite the opposite. With bullish sentiment rising to the peak of the current downtrend – investors should be more inclined to be taking profits, and rebalancing portfolios, rather than taking on additional risk exposure. The current advance, just as we saw from the 2003 bottom to the 2007 peak, was marked by multiple opportunities to add exposure at lower price levels and this will likely be the case again in the not too distant future.

While anything is certainly possible, and we have all seen “irrational exuberance” before, with the current market advance driven solely by “hope” of further Fed intervention, rather than improving fundamentals, it leaves the current advance at risk if said intervention fails to materialize soon. With bullish sentiment advancing sharply in recent weeks it leaves plenty of room for a sell off, within the context of the cyclical bull market, providing the next decent entry point for investors at better price levels.[rate]

Images: Flickr (licence attribution)

About The Author

Lance Roberts – Host of Streettalk Live

After having been in the investing world for more than 25 years from private banking and investment management to private and venture capital; Lance has pretty much “been there and done that” at one point or another. His common sense approach has appealed to audiences for over a decade and continues to grow each and every week.

Lance is also the Chief Editor of the X-Report, a weekly subscriber based-newsletter that is distributed nationwide. The newsletter covers economic, political and market topics as they relate to the management portfolios. A daily financial blog, audio and video’s also keep members informed of the day’s events and how it impacts your money.

Lance’s investment strategies and knowledge have been featured on Fox 26, CNBC, Fox Business News and Fox News. He has been quoted by a litany of publications from the Wall Street Journal, Reuters, The Washington Post all the way to TheStreet.com as well as on several of the nation’s biggest financial blogs such as the Pragmatic Capitalist, Zero Hedge and Seeking Alpha.