The bear market is coming — and it’s going to be painful

The bear market, when it comes, will be especially painful.

That’s because more and more stock-market timers are treating pullbacks as a buying opportunity. That’s a telltale sign of growing exuberance, which is bearish from a contrarian point of view.

The reason the market timers have become so exuberant is that each of the market’s pullbacks over the last year has turned out to be shallow, which has led them to conclude that pullbacks should be treated as buying opportunities.

As a result, the “Wall of Worry” that bull markets like to climb has become ever weaker. That, in turn, suggests that rebuilding that Wall — that is, persuading market timers that every decline is not necessarily a buying opportunity — will require a deep and painful market decline.

This growing exuberance is illustrated in the accompanying chart, which plots the average recommended equity-exposure level among a subset of several dozen short-term stock-market timers. (This average is represented in the chart by the Hulbert Stock Newsletter Sentiment Index, or HSNSI.)

Notice the trend of higher and higher lows. A year ago, for example, the HSNSI got as low as minus 15%. During the market’s July-August decline, in contrast, the HSNSI never got lower than plus 12%. In September’s pullback, the lowest level was 32%, and in the most recent decline the HSNSI’s lowest level has been 52%.

The textbook illustration of why this pattern is dangerous comes from the top of the dot-com bubble in early 2000. That was definitely a period of irrational exuberance, you may recall, fueled by the stock market’s extraordinary rise in the late 1990s, in which every pullback was indeed a buying opportunity. So when the market did top out in March 2000, most market timers were confident that this decline would be yet another great occasion to increase their equity stake. Incredibly, at the point when the market had declined 10% from its all-time high, the average recommended equity-exposure level among market timers focusing on the Nasdaq COMP was higher than it was at that top. That was irrational exuberance.

Story Continues

This analysis doesn’t tell us when the market will top out — only that risk is abnormally high. Contrary analysis has struggled this year, as many of you no doubt know. More often than not this year (63% of the time, in fact), the HSHSI has been in the shaded region at the top of the chart that I use to represent excessive optimism. And yet, overall this year, the stock market has risen strongly.

Nevertheless, we know that the stock market will not keep going up forever. Contrarian analysis suggests that the top could happen at any time and that, when it does, the decline could be particularly deep and painful.

In addition to the HSNSI, my firm also calculates three other sentiment indexes: One for the Nasdaq-focused stock-market timers, one for gold timers and a third for the U.S. bond-market timers. The chart below summarizes where all four of these indexes currently stand relative to their histories.

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