Why optimistic investors are bad for stocks

(MoneyWatch) Recent market weakness aside, stocks just logged their best first quarter since 1998, volatility has quieted down dramatically, and investors are very optimistic about their prospects. Unfortunately, that sunny disposition could be a harbinger of bad things to come, at least in the short term, says Liz Ann Sonders, chief investment strategist at Charles Schwab (SCHW).

Bullishness, or elevated optimism, is a contrarian indicator. When everyone thinks stocks are going to go up, all the buyers have already bought, the thinking goes. That makes stocks poised for a fall. (Bearishness, or excessive pessimism, is also a contrarian indicator, because all the sellers have presumably already sold, priming the market for future gains.)

Sonders fears the remarkable run-up in share prices may have left too many investors "comfortably numb." Relentlessly rising stock prices have bred investor complacency, she writes in a new note to clients. And although long-term optimism is warranted, "the market may be vulnerable in the short term," she says.

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A good way to measure investor complacency is the market's volatility. The CBOE Volatility Index (VIX) -- also known as the "investor fear gauge" -- has fallen precipitously since last summer, Sonders notes.

"The CBOE Volatility Index has dropped dramatically from its high of 48 last August (when Washington's fearless leaders failed to construct a debt deal, leading to Standard & Poor's downgrade of U.S. debt) to 15 recently," writes Sonders.

See how the fear gauge has performed over the last four years in the chart below:

Sonders optimism in the medium- to long-term remains intact, she writes, thanks to 26 consecutive week of better-than-expected economic news, among other factors. That said, the strategist says a touch of caution may be warranted these days. "I do think the market has become more vulnerable to negative news in the short term," Sonders writes.

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    Dan Burrows, a veteran of Aol's DailyFinance, SmartMoney and MarketWatch from Dow Jones, covers the markets and economy with an eye toward investing for the long haul.

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