On July 23rd the percentage of bulls in the stock market, as measured by the American Association of Individual Investors, jumped 10%. And not only did the survey reveal a huge increase in bullish sentiment, the number of investors who see themselves as bearish dropped 11%. In one day!

Commenting on the story, Steve McDonald, editor of the Bond Trader, had some strong words for individual investors chasing this stock market rally,

"The small investor, who is always the last to arrive, has out done himself this time. Chasing performance, or yesterday’s winner, has always been a short cut to the poor house, but this sudden shift in sentiment is a new low in investor behavior."

The numbers supporting this huge shift in investor sentiment are backed up by the Daily Sentiment Index

The DSI is one of the best contrary opinion indicators. A bullish stock reading of anything near 90% or higher is an indicator of a short-term top. Anything near 10% or lower indicates a bottom. Last week, the DSI was 88% bullish – well above the usual 60% to 70%.

Steve McDonald was urging investors to buy near the lows in March. So, what does he think about the markets today?

"In my 25 years in the stock markets I have never seen the small investor act more insanely. To jump into a market that has already run up 41% in five month is so out of line with sound investment thinking, it has left me at a loss for words – and that doesn’t happen often."

"This is the first really big, obvious indication of a serious fracture in this rally. There have been all kinds of subtle signs for the past month, but there is no longer any doubt. It’s over."

The most unfortunate part of this scenario is that the little guy, who got crushed last fall, is likely to get it again...

Steve is not the only IDE analyst who thinks the buy high and sell low crowd is lining up for another drubbing, and that you should proceed with caution. Andrew Gordon, editor of INCOME, is beating the same drum.

Andy points out that investor optimism has surged, despite an extraordinarily weak economy. The stock market is up almost 50% since March, while jobs, cars, houses and big ticket items are all slumping. In an email this week, he writes:

"The stock market trades 80% on psychology and 20% on fundamentals. No way can you justify this 50% rise on fundamentals. Chalk it up to crazy, unwarranted and temporary optimism."

"It happens all the time in the market. Besides using 80/20 breakdowns, I also believe in 98/2 breakdowns. I’ve been watching the markets for a very long time. And I’m convinced that stock markets are in emotional equilibrium around 2% of the time. The rest of the time, markets are either overly hopeful or overly despairing."

And that brings us to the biggest hoax perpetrated on investors of all time…

The efficient market hypothesis assumes that we’re all rational investors, like mainstream economics assumes we’re all rational buyers. Yeah, right. It’s like writing physics formulas without taking into account friction.

The higher stock prices go, the more irresistible the market becomes…

So, it appears that investors have become overly hopeful. This is where the fear of losing money gives way to the fear of missing big gains. Investors have $3.5 trillion tucked away in money market funds. Look for a chunk of this money – dumb money – to switch to the stock market.

Don’t follow the dumb money. And certainly don’t jump in with both feet. It’s much too risky right now. But neither should you sell just because the market is surging higher and appears to be overextended.

A rally is a rally. Whether it’s built on false hope or solid fundamentals, it’s hard to say when it will end.

If a rally can go up this much on the basis of so little real economic growth, it can continue to run from here. Why should it stop at 50%... why not 60%? It’s simply a matter of a crazy market getting crazier.

The world’s greatest investors don’t try to time the market. Great investors let their winners run. But they also cut their losses short and mind their trailing stops religiously. You should too.

Good Investing,

Bob Irish
Investment Director
Investor’s Daily Edge

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