It is time to check in again on what contrarian analysis is saying about the stock market, now that the bulk of the April-May rally has been erased. Unfortunately, the news is not good.
Contrarian analysis tries to forecast the market by interpreting investor psychology -- using the premise that a majority of investors are wrong at the market's major turning points. A bear market bottom usually occurs when most investors are pessimistic, for example, while bull markets typically end when most people believe that stocks have no where to go but up.
On May 6, the last time I wrote about contrarian analysis, the stock market was in the sixth week of a powerful rally that had already sent the Dow Jones industrial average climbing 17 percent and the NASDAQ composite more than 30 percent. Because investor psychology at that time was quite cheerful, contrarians were convinced that the bear market was not over.
Contrarian analysis comes to the same conclusion today. To be sure, average investors are not as cheerful as they were four months ago. Nevertheless, there is little evidence of the thorough pessimism and despair that would persuade contrarians that a bear market bottom was at hand. In fact, investors' current mood is closer to complacency.
Consider investment newsletter editors, whom contrarians have used for decades as a reliable gauge of that mood. On average, the percentage of portfolios that those editors recommend be allocated to equities is markedly higher than in March, when the market was trading about where it is now.
The relative complacency is particularly evident among market timers who focus on the NASDAQ market.
When the NASDAQ index first dropped to 1,800 in early April, the average exposure among these timers plunged to an incredibly pessimistic level of minus 69 percent, according to figures compiled by The Hulbert Financial Digest. (The negative reading indicated that the average recommendation of these timers was to be short the market, an aggressive strategy that makes money only if the market declines.) As of Thursday, the average exposure among these timers was significantly less pessimistic, at minus 57 percent.
Call premiums are at historically low levels, so investors should be using the put-buying strategy more heavily. Instead, they prefer call-writing, according to data collected by Bernie Schaeffer, editor of the Option Advisor service.
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