There is nothing like a bull market to make investors feel great. But don’t let optimistic data lead you into complacency. The market is at its most dangerous right when everyone agrees it’s strong.
Think about it. When everyone is bullish, theoretically, they have already bought. If there is nobody left to buy, demand dries up, and the slightest bit of bad news can trigger a stampede to the exit doors as many people try to sell at the same time.
As you can guess, the next bear market can start in a hurry.
That’s exactly what we saw when the Internet bubble popped in 2000. And when the housing and financial bubble popped in 2007.
Fortunately, investors can use three indicators as early warning signals.
When one or more of them go off, we’ll know that it’s time to play it a bit more conservatively or even step aside completely with all but core holdings.
And these indicators are the last place most investors will look…
Markets Move in Cycles
If you know where to look, you will see the natural ebb and flow in the stock market trace out regular periods.
Think about the annual market cycle, where some parts of the year are usually strong and others are usually weak. You may have heard this common witticism: “Sell in May and go away.” The winter months – on average – perform better than the summer months.
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You may also have heard of the presidential, or four-year, cycle. Right now, the market is in the third year of the cycle. That means that if the cycle holds, the market should run into serious trouble in 2020.
Of course, that is just the average cycle. Economic or political events can make it longer or shorter, so the takeaway here is that the cycle is aging but not dead yet. Later this year, strategies should probably turn a bit more defensive.
In short, investors seeing market gains after the worst December for stocks in 30 years shouldn’t get too optimistic.
Merger Activity Peaks Ahead of Bear Markets
Bull markets make companies feel good, too. After all, they are making money, and their share prices are moving higher. They look for ways to grow their businesses, and since their shares are inflated in price, they use them as currency to buy their rivals or suppliers.
Merger and acquisition activity starts to grow, and eventually companies become willing to take more risk and pay higher prices for their targets. It’s just like an individual investor chasing Bitcoin higher in 2018. We know how that ended up.
The same is true in the stock market when corporations chase deals.
Right now, the data shows a decent spike in global merger activity in early 2018. There is usually a lag between the merger peak and the stock market peak, so this particular indicator suggests that investors keep their eyes open. The exact timing, however, is not well defined.
It’s simply a reminder that deal activity picking up doesn’t mean the market will keep growing.
In fact, investors getting confident is another sign the market could turn bad…
Investors Are Optimistic Until the End
Finally, we can look at investor sentiment itself.
The American Association of Individual Investors publishes a sentiment survey every week, noting how many respondents are bullish, bearish, or neutral for the next several months.
For the week ending Wednesday, Feb. 13, the survey shows 35.1% bullish, which is just shy of the 38.2% historical average. Interestingly, the bearish reading is 25.1%, which is also just shy of the historical average of 30.3%. The difference is the rise in neutral sentiment.
Right now, the survey does not tell us too much. If and when it moves to an extreme in bullishness or bearishness, we will then get an indication about the market’s condition.
At the bottom of the 2008 bear market, the bearish reading spiked to over 70%. It was so bearish, it was actually bullish! So many people were scared out of the market and already sold their holdings that the market became poised for a bullish move. Nobody was left to sell.
That is called contrarianism. Going against the crowd. The condition here is that the crowd must really be a crowd, so don’t sell just because a few of your friends are really bullish.
As Howard Marks, co-chair of Oaktree Capital Management, put it, “extraordinary performance comes only from correct non-consensus forecasts, but non-consensus forecasts are hard to make.”
When the economy is roaring and the market is following suit, it can be hard to bet against it, but sometimes that’s the best play. That’s why we wait for the market to tell us that consensus is wrong via these indicators. We’re not quite there yet, but always keep them in mind.
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