Bullish Extremes Herald at Least a Steep Correction for Stocks

Last Updated Jan 17, 2010 4:47 PM EST

The key to being a successful contrarian, beyond possessing a certain ornery skepticism, is an ability to identify extremes in investor sentiment and position your portfolio for a move in the opposite direction.

The stock market remains near the top of a five-month, 50 percent rally, so signs of optimism would be expected. But by some criteria, bullishness surpasses even the levels reached at the all-time high in 2007, about 5,000 points ago on the Dow Jones industrial average. That suggests that a correction of the advance - and possibly something much worse - is near.

The latest issue of Elliott Wave Financial Forecast highlights an indicator called the Trading Index, or TRIN, that assesses investors' mood by comparing trading volume in rising versus falling stocks. A low TRIN reading, less than 1, indicates that volume is concentrated in rising stocks and means that bullishness is rife; a reading above 1 is a sign of bearishness.

A 21-day moving average of the TRIN - used to smooth out jerky day-to-day swings - fell to 0.881 on Aug. 27, the newsletter said. That is almost exactly the same level (0.880) as on Oct. 9, 2007, the day the Dow closed at its record high of 14,164. By contrast, the TRIN rose above 1.6 during four periods in the last two years, each corresponding to a climactic low.

The editors, Steve Hochberg and Pete Kendall, view the latest spike down in the TRIN as evidence that "investors are rushing into rising stocks in hopes of making back their . . . losses" from the bear market. They are urging subscribers to rush out; they expect stocks to fall well below the bottom reached in March.

If you want to know how investors feel, one approach is to just ask them. That's what a research firm called Investors Intelligence does. It takes snapshots of the public's mood by surveying editors of investment newsletters. As with the TRIN, a reading indicating strong bullishness tends to correspond to highs in the stock market and foretells a decline.

In the same week as the TRIN reached its latest bullish extreme, the Investors Intelligence survey showed the highest ratio of bulls to bears and smallest proportion of bears since - guess when - the 2007 top.

Corporate insiders are an exception to the rule. Executives tend to have a knack for gauging business prospects at their companies with ruthless dispassion, so it's a good sign when they're buying their own stock and a bad one when they're selling.

Although it works in reverse from other sentiment indicators, insider activity is telling the same story. Insiders sold 30.6 times as much of their companies' stock in August as they bought, according to TrimTabs Investment Research; that is the most for any month since the firm began tracking such data in 2004.

"The best-informed market participants are sending a clear signal that the party on Wall Street is going to end soon," Charles Biderman, TrimTabs' chief executive, said in a note accompanying the data.

Biderman highlighted similar signals from less well informed investors. The amount of shares sold short on the New York Stock Exchange plunged by 10.3 percent in the second half of July. That shows that many short sellers have thrown in the towel and are no longer willing to bet that share prices will fall.

Margin debt rose 5.9 percent in July. That indicates that smaller investors are so confident in their outlook for stocks that they are willing to borrow money to increase their exposure.

Any one sentiment measure means little, but when many of them confirm that the collective mood has reached an extreme and is not just tilting a bit one way or the other, it's a good idea to heed them. Veteran market observers like Hochberg, Kendall and Biderman all advise selling stocks.

"When corporate insiders are bailing, the shorts are covering and investors are borrowing to buy," Biderman said, "it generally pays to be a seller rather than a buyer of stock."