The five-month rally in the US stock market is coming to an end. Of course I don't know when. This is important to acknowledge as I have been arguing since this spring why the market lows could be retested in March in mid-June or mid-August. As many of you recently emailed me to remind me, neither scenario has occurred.
Nevertheless, the conditions for a correction are now even better. One big reason is that short-term market timers have become extremely bullish, which is not a good sign from a contrary perspective. This is illustrated in the graph below, which shows the average recommended equity exposure among nearly 100 such timers that my company monitors on a daily basis (this is the Hulbert Stock Newsletter Sentiment Index, or HSNSI). This average is currently 65.9% – more than 95% of all daily readings since 2000 when my company started calculating this index.
The graph also shows the cases in which the HSNSI has risen to the top 10% of all previous measured values in the last few years and thus fulfills the criterion for excessive upward movement established by some contrarians. You will find that the market has struggled on previous occasions when this criterion was met.
However, the diagram only covers the last two years. However, what is shown in the table is confirmed by the full database by the year 2000 – as can be seen in the table below.
Russell 2000 the following week
Russell 2000 the following month
Russell 2000 the following quarter
Russell 2000 for the next 6 months
Top decile of HSNSI readings since 2000
That was all the days since 2000 Not Part of the upper decile
The lesson I learn from the data is that we should keep our excitement in check. The stock market has been surprisingly strong for the past five months, but – as famous British economist John Maynard Keynes fondly reminded investors – trees don't rise to the sky.
Corrections are customary before election day
Another reason to expect at least a pullback is that there has almost always been a market decline in the three months leading up to the presidential election. That's what I found out when I examined the behavior of the Dow Jones Industrial Average
between mid-August and Election Day in every election year since 1900. On average, the Dow was more than 5% lower than mid-August at one point during these three-month period.
Read: Nasdaq is setting a record momentum that has seen declines in the past
If the stock market experiences a similar pullback, it means the Dow will be 1,400 points lower between now and early November than it is today. That's just the average. The worst correction in that period from mid-August to Election Day was 2008, when the Dow fell 30% from mid-August to its pre-election day low.
Well worth thinking about this terrible experience. You can dismiss it as irrelevant to today's market, but at a point similar to 12 years ago today – in August 2008 – the market timers were also quite optimistic. Little did they know that in the next 60 days, Lehman Brothers would collapse and bring almost the entire global financial system to a standstill.
I keep a file with all the bullish forecasts that Market Timer made in August 2008. That way, I can easily retrieve them when customers are too confident about what the future holds for them. The following proclamations were made in late August 2008 – two weeks before Lehman Brothers went bankrupt:
“I'm ready to be a cop again! … The real estate market is beginning to show serious signs of bottom … The financial sector has slowly recovered. "
"At least for the next few weeks the sun will shine on the stock market … (D) The credit crisis seems to be coming to an end … (A) All of these factors have reduced the downside risk in share prices for the time being. ”
(Due to falling commodity prices) Consumers will … get much-needed breathing space. This will allow the economy to regain its footing and begin a recovery. "
(D) The subprime chaos is largely behind us … I think a 75% invested stance is about right at this point. "
The final result? Don't be surprised if the stock market takes a nasty decline in the coming weeks.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings track investment newsletters that pay a flat fee for testing. He can be reached at email@example.com
Read:If history repeats itself, the stock market will hit a new high in late August
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