Overly Optimistic Stock Market Sentiment Flashes Warning Sign!

By The Curmudgeon

The CURMUDGEON has not been bullish on the 2013 stock market, despite the explosive rally the first two weeks of this year.  We believe that all the good news is in the market and that recent bullish optimism indicates a stock market top is near. 

As per previous posts, we've been skeptical of the November 2012 to January 2013 rally because:

1. We thought the fiscal cliff deal had already been factored into U.S. stock prices.  This despite the fact that none of the real budget deficit and debt ceiling problems have been solved and have been once again "kicked down the road."

2. Earnings momentum has been declining for over 1 year now, while the ratio of U.S corporate earnings to GDP is at an all-time high.

3. There's way too much investor complacency, as indicated by 5 year low on the VIX.  Also, analysts interviewed by Barron’s are universally bullish as is the current sentiment readings. 

In particular, we cite the following evidence of bullish sentiment and complacency:

• Investors Intelligence U.S. Advisor Bullish percentage has increased to 51.1% on Jan 9th vs. 37.2% on Nov 21st
• AAII Investor Sentiment Survey indicates 46.4% of investors were bullish as of Jan 9th.  That  was up 7.7% on the week and significantly above the long term average reading of 39.0%
• The current Consensus Bullish Sentiment 51% vs. 45% 2 weeks ago.
• Market Vane's Bullish Consensus of future's traders is at 66% - not too far from its October 2007 all-time high of 71, which coincided with the previous bull market peak.
• Investors have been piling into U.S. stocks at near record pace to start 2013.  The latest Bank of America Merrill Lynch Global Research report shows a $19 billion inflow into U.S. equity funds for the first full week of 2013.  That’s the biggest surge since June of 2008 and the fourth highest since 2000, according to the report. Equities have seen inflows over the past 7 weeks, according to the report.
• According to Lipper, equity funds, including exchange-traded funds, took in $18.3 billion for the week ended Jan. 9th.  That was the fourth largest net inflows since Lipper began calculating weekly flows in January 1992. Some $10.8 billion poured into equity ETFs, while mutual funds took in more than $7.5 billion, their largest inflow since the week ended May 2, 2001.
• The Rydex Ratio (calculated by dividing total Money Market plus Bear Assets by total Bull assets in the Rydex mutual fund group) currently is at the extreme bullish end of the normal range as shown in this chart:
  
  

http://www.financialsense.com/contributors/carl-swenlin/rydex-ratio-implies-price-top-near

• It's important to note that total Rydex bear fund assets have fallen to levels not seen since the 1998 market top, showing that the bears are unusually timid. 
• Meanwhile, Rydex money fund assets are dropping to levels frequently associated with stock market tops. Sideline cash is getting very low at Rydex, which implies investors are already invested in bullish stock mutual funds.

Sentiment alone is insufficient to call a market top, but it is definitely a warning sign.   Historical high readings of bullish sentiment almost always indicated a major stock market top was at hand.  Caveat emptor!

Until next time...........................................

The Curmudgeon

Curmudgeon is a retired investment professional.  He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996.  He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.