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By: Chris Rowe — December 26, 2013

Technical Tuesday: WARNING: Strong Market... But Watch for a TOP

Happy New Year!  Please be sure to open tomorrow's Tycoon Report, where I will announce big changes and new features for you in 2014!

Here's a quick heads up to encourage you to stay sober -- at least in terms of the stock market.

This market is like a lava lamp that has tilted too far to one side.  The "liquid" is almost completely on that one side.  The more liquid that fills up the right side, the more that must then spill back to the left.

This short article, about the Advisors Sentiment readings, will prove to you why bullish investors should begin to pull in the reins for the time being.  These extreme readings are currently showing dangerously bullish levels not seen since the all time high set back in 2007.

I'll show you what I mean in a minute.  But first...

Does that mean we are at the long-term bull market top?  No it doesn't.  Overbought doesn't mean "over".  But when you see readings like this, it's cause for pause and time to prepare for a market correction. 

U.S. equities continue to be the dominant asset class out of:

  • Non-U.S. equities (both developed and emerging)
  • Commodities
  • Fixed Income (government, corporate, preferred equity)
  • Cash

The U.S equity market is currently strong, and 2014 could prove to be a bullish year, but there have been cracks showing up in the foundation. 

This article focuses on a concept that is the easiest to understand but the hardest to overcome: human emotion.  I'll show you proof using historic statistics compared to the market action that followed.

But first consider the bare bone basics...

When there are too many buyers that own too much stock, there is that much more stock that will quickly be sold when the mood changes.  At the same time, when investors are "fully invested" they tend to run out of cash for new positions (less available cash to fuel the next price advance).

Also, consider what happens when there are too few bears (too few investors betting on stocks declining in price). 

The way falling stock prices tend to find their first bottom is when bearish traders exit their positions.  Thus, when there are too few bearish positions in existence, there's not enough fuel to fan a rebound any time soon.

Investors who sold short stock must buy back huge short positions in order to take a profit.  Remember, the way short sellers trade is they first sell a stock and then later close out their bearish "short" positions by entering huge buy orders, thus causing prices to advance and a bottom to form.  Eventually new bulls become brave enough to buy stock at that same "support" level. 

Now consider this...

A lack of short sellers means there's that much more room for new short positions to get initiated.  This means lots of sell orders pushing prices down. 

In addition to that, because funds are so heavily invested right now, there will be a lot of stock for sale if any kind of fear hits the market.

I'm not saying the long-term uptrend is broken.  I'm just saying that today's situation is the inverse to the argument that "there's just so much cash sitting on the sidelines right now waiting to buy stocks." 

There's not much more fuel for the bullish fire, but there's tons of fuel for the other side of the trade.


How Can I Just Sit Back And Watch?

I know it can be very painful to sit on the sidelines TO ANY EXTENT while markets are breaking highs.  It's almost as painful as sitting in the stock market during a bear market as prices decline. 

It's psychologically easier to be part of a big group that's losing money in a bear market than it is to be part of a small group sitting in cash while, seemingly, everyone else is profiting.  It's human nature.  And fighting human nature is difficult for ANY human to do.  For kids, it's virtually impossible.  But as we grow older we at least realize the importance of trying fight against our natural instincts. 


How Today's Bulls are Much Like my 4-Year Old

As a parent, I've found lots of parallels between market guidance and things I say to my kids. 

Maybe the parents reading this can relate, but a few times each week I find myself saying the words: "Yeah,  but nobody ever fell on their head on purpose!" 

My son, Lincoln, broke his little 4-year old elbow a couple of months ago after jumping on his bed when nobody was looking.  I always told him not to, because he could fall and hurt himself.  Of course, he'd say:  "I'm not going to fall."  Hey, 19 out of 20 times (at least) the little guy is right.  But the stakes are too high.  And this reminds me of the stock market today. 

The reason the Investors Intelligence Advisors Sentiment Charts are in extreme bullish territory -- a major sign of a near top -- is that so many people are saying they aren't going to fall

Each week, Investors Intelligence reads over 100 publications from newsletter writers and independent investment advisors.  They report on whether they are "bullish", "bearish" or "looking for a correction". 

When over 55% are bullish, it's a red flag that we are at or close to a top (which is the level reported in the third week of May -- right before Bernanke started talking "tapering," which caused a correction).  But the closer the percentage of those polled being bullish gets to 60%, the more dangerous it is to be bullish. 

Just as dangerous as having too few bulls is having too few bears.  Today the poll's percentage of bearish advisors is at a near 27-year low!  (March 20, 1987 -- 13.7% of advisors were bearish.  The S&P 500 advanced another 10% and then lost 1/3 of its value, 20.5% in a single day). 

Again, I'm not saying that's about to happen, but take note!

What are the current sentiment levels?

Today, the reading shows 59.6% of advisors polled are bullish!  

That's well above the 55% "red flag" mark and closing in on the key 60% level.  Let's not split hairs here.

To put it into context:

  • October, 2007 bull market top (blue arrow, below): 62% of advisors were bullish.

    We are currently witnessing the largest percentage of bulls since then (59.6%).  Over the following 18 months, the S&P 500 declined 57.7%.
     

  • May, 2011 bull market top (red arrow): 57.3% of advisors were bullish 1 week prior.  Over the following 5 months, the S&P 500 declined 21.63% from intraday high to low.

    Interestingly enough, 59% were bullish 5 months prior to that at the turn of the year 2010 - 2011.  That reading was followed by a 6.9% advance in the S&P 500 to the Feb 18 high, a 6.86% correction and then a recovery.  The recovery only led to slightly higher levels than the Feb 18 high -- 2.01% higher to be exact (see below). 

    Although the main stream media says our current bull market started in 2009, it ended in May 2011.  A new bull market -- which we are currently in -- technically got started in October of 2011.
     

  • December 31, 2013: 59.6% of advisors are bullish.  I don't know if this bull market is in the final stages or not.  It seems pretty strong, long-term, at this point.  We shall see. But it would pay to take some chips off of the table or tighten up your stops and hedge for an intermediate-term correction. 

    There's more...

    New sentiment numbers will be reported again tonight.  I will keep you posted and continue to discuss the strongest places to have your capital invested and the riskiest places to be.

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Sure, at the October 2007 high (blue arrow), an astounding 62% of those polled were bullish (again, the reading is currently a bit lower, at 59.6%).

But at the October 2007 market high, only 19% of those polled were bearish (the bearish reading, even more extreme today, is at 14.1%). 

At the more recent peak in bullish advisors in April 2011, 57.3% were bullish.  The 2011 high was set in the first week of May and experienced a mini crash that summer (after the U.S. credit rating was downgraded by S&P). 

What about bearish readings?  In April 2011 as few as 15.7% of advisors were bearish.

Today, the bears are even lower at 14.1%. Those are the lowest figures since a 13.6% reading on March 20, 1987.

Let's look at this differently -- viewing the SPREAD between the % of bulls vs. the % of bears is very useful too. When the spread is higher, advisors are more bullish. 

For example, today 59.6% of advisors are bullish and 14.1% are bearish.

A spread above 35 is considered a red flag, and when it hits 40 it's considered extreme (overly bullish) territory.

The difference today is 45.5% (59.6 - 14.1). 

I'm not sure when the last time was that there was this big of a difference, but it isn't seen on this 10-year chart.

In April 2011 we had a 41.6% spread/difference and in October 2007 we had a 42.4% spread/difference.

So to sum it all up, this sentiment indicator, which is a contrary indicator and one of the few LEADING indicators (signals BEFORE the move actually starts to occur), is showing more bullishness than in April 2011, at the last bull market high. 

And depending on how you look at it, it's more bullish than the October 2007 high (the difference between % bulls and % bears).  If you want to focus only on the % of bullish advisors, we are certainly higher than the April 2011 high, and we are only 2.4 percentage points away from the levels seen in October 2007. 

So put that in your pipe and smoke it, Frosty. 

Now, markets can stay overbought for a long time.  And I'm not rooting for a bear market or a bull market.  I just want you to keep your profits, no matter how painful it may be to lock in your 30% profit and sit on the sidelines while you watch it grow to what would have been a 50% profit. 

Sometimes in the investing world we have to do things that are very uncomfortable.  It's most uncomfortable when everyone else is doing something different than you (human nature).  Chances are pretty close to 0% that you'll sell at the top, which means chances are close to 100% that you'll sell bullish positions and then deal with the pain of seeing them advance. 

Similarly, it's also uncomfortable to sell your bullish positions at a loss, after witnessing the bear market ensue, but before a much much bigger decline comes.

You don't have to just sell everything tomorrow.  This is not an emergency.  But be picky about what you hold.  Consider getting a bit more conservative here.  Instead of individual stocks, focus on sector ETFs that are less volatile.  For your existing bullish positions, put a tight stop loss order on or sell call options against your position (at the money call options that expire 20 - 40 days out).  Or do both! 

If you do both, just make sure that your trade is set up so you don't end up with NO STOCK position but still short the call options.  In other words, set it up so that if you get "stopped out" of your long stock position, the order closes out the stock position as well as the short call (or else it will no longer be a "covered" call).    
  
It's extremely difficult and frustrating to focus on the week to week and month to month moves.  But the most reliable signals and indicators tend to be the more intermediate-term to long-term indicators, and the one we've studied today has an amazing long-term track record.  

Speaking of long-term track records, I've recently started playing around in LinkedIn more lately.  And it occurs to me, on this last day of 2013, that many people reading this have been following me for many years. 

I literally have thousands of testimonials from you guys over the years, but I've kept almost all of them private.  If you are one of my LinkedIn connections and had good experiences with me, go ahead and write me a short recommendation by scrolling about half way down the profile page to the "Recommendations" section where it says "Would you like to recommend Chris".  It will make me feel warm and fuzzy.

Anyway, be safe!  I hope you enjoy the final hours of 2013!  And I look forward to working with you in the new year!

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