Don’t get too optimistic about a stock market rally — they’ve been fizzling out

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Stock-market timers have responded to recent strength in equities by quickly becoming more bullish. By so doing, they are making it less likely that the rally can continue for much longer.

Their quick shift from bearish to bullish is in line with the scenario I laid out three weeks ago, when I last analyzed sentiment among stock-market timers. As I wrote then, the market timers “are quick to jump on the bullish bandwagon when the market rallies, and then jump on the bearish bandwagon when the market declines. As a result, both rallies and declines tend to be short-lived.”

Short-lived they have been. The early-May decline, which was the occasion for my three-weeks-ago column, lasted just 18 calendar days, over which time the Nasdaq Composite Index fell 5.5%. The average Nasdaq-focused market timer my firm monitors reacted as though the world was coming to an end, reducing their average recommended equity exposure level by 98 percentage points. That is a dramatic reduction for so short a period. (This exposure level is what’s measured by the Hulbert Nasdaq Newsletter Sentiment Index, or HNNSI.)

That set up the sentiment preconditions for a subsequent rally which, at least so far, has lasted 16 calendar days. During that time the Nasdaq Composite gained 3.4% and the market timers are behaving as though their mid-May despair was ancient history. The HNNSI has risen 67 percentage points.

New normal

This quick jumping onto and off of the bullish and bearish bandwagons has become the new normal, as you can see from the table below. It reports the last three significant rallies and the last three significant declines, with “significant” defined by large shifts in the HNNSI. Notice how the timers are quick to run scared at the first sign of trouble, and quick to jump on the bullish bandwagon when the market shows any strength.

               

Percentage change in Nasdaq Change in HNNSI Number of days HNNSI percentile at end
Declines
2/9 to 3/8 -10.0% -114% 29 16
3/17 to 3/30 -3.5% -50% 13 23
4/29 to 5/17 -5.5% -98% 18 22
Rallies
3/8 to 3/17 +7.3% 71% 9 61
3/30 to 4/29 +8.0% 89% 30 96
5/17 to ? +3.4% 67% 16 67

One consequence is that market-timer sentiment never becomes so low or so high as to enter the zones of “extreme bearishness” or “extreme bullishness.” I define those zones to be the top or bottom decile of the HNNSI’s historical distribution. Notice from the data in the right-most column of the table that, with one exception, none of the recent rallies or declines ended in those extreme deciles.

As I argued three weeks ago, this sentiment pattern suggests that the market may remain in a fairly narrow range for the next several months. The contrarian bet is that the market will finally break out of that trading range whenever the market timers stubbornly hold onto their sentiment beliefs in the face of the market moving in the opposite direction. That is, be on the lookout for when the market timers remain bullish in the face of declines, or bearish in the wake of rallies. That will indicate that a bigger decline or rally is in store.

In the meantime, the market timers’ behavior suggests both market rallies and declines will be subdued. That’s good news to the extent you were worried that a major new bear market is about to begin, but bad news if you were hoping for a more sustained rally.

Market timers in the stock and bond arenas

The Nasdaq market is just one of four arenas in which I track market timers’ average exposure levels. The others are the general stock market, the gold market and bonds. Each month in this space I highlight one of them and analyze what it’s saying from a contrarian point of view.

In the meantime, the chart above summarizes where the timers currently stand in all four arenas.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com.

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