Sentiment Shift Hits Stocks

2/15/2010


Trading has turned volatile, with the Dow Industrials adding or losing more than 100 points on most of the trading days since the Jan. 19 closing high of 10,725.43. Volatility is not proof of irrationality or an imminent crash; equity values can fluctuate widely on minor changes in consensus expectations, and all securities prices depend importantly on investor sentiment.

Consider the last few weeks, a period in which investors appear to have lost considerable nerve. The percentage of bullish investment newsletters has dropped to 34.1%, down from 53.4% on Jan. 8, according to Investors Intelligence. The CBOE Volatility Index, a measure of the expected market volatility implied by option prices, has jumped nearly 50% from the 19-month lows reached in mid-January.

Is anybody really surprised that Greece’s finances are a mess? Is it really news that the U.S. has an unsustainable budget deficit, that taxes are almost certainly headed higher? Perhaps December-quarter results were not as good relative to expectations as it appears. But even shares that rallied on blowout results and positive guidance have pulled back from their January highs, suggesting earnings and other news do not fully explain the drop since Jan. 19.

The drop likely reflects a retreat in sentiment from a bullish extreme. Dow Theorists try to distinguish such shifts in sentiment from more enduring trends by identifying significant highs and lows in the Dow Industrials and Dow Transports. All bull markets will suffer secondary corrections because of the ebb and flow of speculative sentiment. But when underlying equity values are improving, such pullbacks are followed by rebounds to new highs.

Typical secondary corrections retrace one-third to two-thirds of the preceding advance. Based on the advances from March to January, such corrections would bring the Industrials to 9,333 to 7,940 and the Transports to 3,558 to 2,852. So, even a typical secondary correction could mean a substantial drop from current levels.

If the averages suffer significant corrections without both closing below the March lows, then both rebound above the January highs, the primary trend would be bullish. If the averages suffer significant corrections and then rebound without both reaching new highs, then both move below the correction lows, the primary trend would be bearish.

What to do now

We are encouraged to see bullish sentiment drop so sharply since mid-January, and we don’t view stocks as expensive considering the outlook for profit growth. But even a typical secondary correction could bring considerable near-term pain, and the lack of a bull-market confirmation suggests the entire move since March may yet prove to be a bear-market rally. As a partial hedge, we’re holding 20% to 25% of equity portfolios in short-term bonds. Especially attractive picks for year-ahead gains include Aflac ($47; AFL), BMC Software ($36; BMC), and IBM ($123; IBM).


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