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Opinion: Here’s how you’ll know the stock market’s slide is for real

Market Analyze with Digital Moniter focus on tip of finger © woraput chawalitphon/Getty Images Market Analyze with Digital Moniter focus on tip of finger

The proverbial wall of worry — the one bull markets like to climb — remains as strong as ever on Wall Street.

With both the Dow Jones Industrial Average (DJIA) and the S&P 500 (SPX)  hitting new all-time highs this past week, sentiment surveys appear to indicate that widespread bullishness has returned and the wall of worry is crumbling.

In truth, investors’ bullishness is a mile wide and an inch deep. As we’ve seen time and again in recent months, bullishness quickly gives way to bearishness at the first sign of trouble. Contrarian-minded investors believe a market top is imminent once this is no longer the case — meaning when investors respond to market weakness by becoming more bullish, not less.

To illustrate how far from that eventuality we currently are, consider the average recommended equity exposure among a subset of stock-market timers I monitor who focus on the Nasdaq (COMP) in particular (as measured by the Hulbert Nasdaq Newsletter Sentiment Index, or HNNSI). Since the Nasdaq responds especially quickly to changes in investor mood, and because those timers are themselves quick to shift their recommended exposure levels, the HNNSI is my most sensitive barometer of investor sentiment.

© Provided by Dow Jones & Company, Inc.

Notice from the above chart how far the HNNSI plunged in the wake of the market’s turmoil in late July and August. From a high of 88.2% in the last week of July, it reached a low of minus 26.5% in the last week of August — a drop in average recommended equity exposure of 115 percentage points in just one month’s time.

That’s an awfully quick run to the exits. And, in true contrarian fashion, the HNNSI’s low reading in late August created the sentiment foundation for the market’s recent run to new all-time highs.

Read: These stocks haven’t been so cheap since 2000

Of course, the chart also suggests that the timers’ average recommended exposure level is now back at the lofty levels seen in late July. That’s an ominous short-term sign from a contrarian perspective — suggesting that the path of least resistance in coming days is more likely to be down. Indeed, that decline may have begun on Thursday, when the Nasdaq declined by 31 points (0.5%).

But any decline is likely to be relatively painless, given the market-timing community’s paranoia that a bear market could begin at any time.

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How will we know when a decline is likely the real thing? Consider how the HNNSI reacted in early 2000 to the bursting of the internet bubble. In the first two weeks after that break, the Nasdaq fell by more than 10% — enough to satisfy the semi-official definition of a correction. Yet, far from falling, the HNNSI over those two weeks actually jumped by more than 30 percentage points.

Instead of running scared, in other words, the average short-term market timer considered the correction to be a buying opportunity. That’s stubborn bullishness — and we all know what happened next.

So pay close attention to how the market timers react when the market next experiences a decline lasting more than a day or two.

If they quickly run for the exits, as they consistently have done in recent months, then it’s a good bet that the decline will be minor. But if they become more bullish in the face of a decline, as they did in March 2000, then run for the hills.

Mark Hulbert has been tracking the advice of more than 160 financial newsletters since 1980. For more information, including descriptions of the Hulbert Sentiment Indices, go to The Hulbert Financial Digest or email mark@hulbertratings.com.

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