New investor optimism tells contrarians time ticking for rally

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New investor optimism tells contrarians time ticking for rally

SAN FRANCISCO (MarketWatch) -- Look out below. Investors are starting to feel a bit happier.

Surveys of investor sentiment, while still negative, have started to perk up in recent weeks as the stock market has jumped off its March 6 lows. They stand a good chance of climbing again this week thanks to Monday's heart-stopping advance.

But a sunnier outlook from the investing masses also raises a note of caution on how far - and how long - this current rally can last. These surveys, particularly those that poll individual investors, are frequently viewed as contrarian indicators.

That is, when small-timers think investing conditions can't get any worse, the so-called smart money has already bought their shares, putting the seeds in place for a rally. Conversely, when everyone at the neighborhood barbeque is trading stock tips, and individual sentiment is rosy as can be, that's probably the sign of a market top.

"Investor sentiment tends to be the herd," notes Andrew Brooks, head of U.S. equity trading at T. Rowe Price. "If the rally gets some signs of extension from here, then perhaps investor sentiment will turn positive, at which point, we will want to sell a little, trim it.

"It might be a signal that the market is getting tired, and might give some [of its gains] back," he said.

On Tuesday, the benchmark indexes retreated after rallying about 5% Monday. The Dow Jones Industrial Average (DJI:^DJI - News) was recently down 55 points, or 0.7%, to 7,720.26, the S&P 500 lost 7.5 points to 815.61 and the Nasdaq composite (COMP - News) fell 25 points, or 1.6%, to 1,530.54.

Rising optimism, of course, doesn't mean the end of the rally. It just signals that some of the cash sitting in bonds or under mattresses has probably moved into stocks, drawing down on the stockpile of investing assets that can push indexes higher and higher.

Brooks, for instance, says the most recent rally has a good foundation - positive earnings statements from banks such as Bank of America Corp. (NYSE:BAC - News) and Citigroup (NYSE:C - News) and a new bank bailout plan - and it's got room to run. T. Rowe Price was buying equities on Monday, as Wall Street came together for its biggest advance in five months.

"I still think we are oversold," he said.

When a sentiment-driven rally starts to love steam can depend on how sour sentiment had turned.

Think unripe lemons. That's how bitter investors felt about stocks earlier this month.

The American Association of Individual Investors' weekly online survey found about 70% of respondents were bearish on the market in the short term, the highest since the association started to poll members in 1987.

In weeks since, the portion of bearish investors has plunged - to 55% in the week of March 12 and 38% last week. The association next publishes results of its survey Thursday.
Polling firm Gallup has also found investors starting to look up.

Late Monday, it said its index of investor optimism surged 41 points in March to negative 23. That means investors polled are still pessimistic, just not as dour as they were in February, when the reading came in at negative 64.

Similarly, a survey of stock advice newsletters tracked by Investors Intelligence has also risen in recent weeks. In its March 18 release, the survey found 44% of newsletter advisors were bearish, down from 47% the prior week, which was the grimmest outlook shared by these surveyed writers since mid-December. Those with a bullish stance were still in the minority, or 28%, but they were up from a 2009 low reached the prior week.

Mixed track record

So how successful are these surveys at predicting market tops and bottoms?

Bearish lows in the AAII's individual investor survey have coincided with market tops in recent years. But there have also been plenty of false signals.

In October 2007, the month when the S&P 500 peaked and started on its 18-month bear market, as few as 25% of respondents were bearish. This optimism seemed to signal a market turning point. Since its Oct. 2007 high, the S&P 500 has lost 48% of its value.

But recent high points in bearishness have not translated into lasting advances.

In the week of Oct. 9, bearish sentiment spiked to 61%, the worst reading since 1990. The S&P 500 rallied 11% over roughly the next month, topping 1,005 points. But in the months following it gave up those gains, tumbling as low as 666 points on March 6.

Bearish sentiment outweighed bullish sentiment from mid-January to mid-March - and stocks kept falling.

"Sentiment has been bearish for quite some time so sentiment indicators have been misleading," said Ed Yardeni, president and chief investment strategist of Yardeni Research Inc., an investment strategy consultancy in Great Neck, New York.

"If you used that as a contrary indicator to load up on stocks, you've probably been ripped out of the market," he said. Instead of negative sentiment, he said, financials are to thank for the past weeks' rebound.

"It's driven by news that financial rescue plans might be big enough to finally make a difference."

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