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Mark Hulbert: The stock market is casting a pall on investor morale — but the mood isn’t gloomy enough to start buying

The stock market decline has further to go.

That’s the surprising conclusion reached by a contrarian analysis of market sentiment.

I say “surprising” because the Dow Jones Industrial Average DJIA, -1.81% has shed 1,300 points in less than a week. That normally would darken Wall Street’s mood sufficiently to cause contrarian traders to turn bullish.

But not this time around, at least not yet. Contrarians grade the sentiment of short-term market timers as little better than neutral.

Consider the average recommended equity exposure level among a subset of Nasdaq-focused stock market timers that my firm monitors on a daily basis. (This average is what’s reflected in the Hulbert Nasdaq Newsletter Sentiment Index, or HNNSI.)

Since the Nasdaq COMP, -1.84% 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 in the U.S. equity market.

This average currently stands at minus 3.6%, which means that the short-term market timers on balance are allocating a small portion of their equity trading portfolio to shorting the market. (Shorting, or short-selling, means betting on a decline.)

While that’s a lot lower than the excessively bullish readings registered several weeks ago, it remains a lot higher than the extremely pessimistic readings that accompanied significant bottoms of recent years.

This is illustrated in the accompanying chart, above. The shaded region at the bottom indicates the range of HNNSI readings that fall in the lowest 10% of its historical distribution. This is the range that in past columns I have used to indicate excessive pessimism. Notice that the latest HNNSI value remains well above that bottom decile. In fact, its latest reading is higher than 27.8% of all daily readings since 2000.

Contrarians won’t be inclined to step up to the plate and buy equities until the HNNSI drops down into the lowest decile, the upper end of which is minus 41.7%. That’s 38 percentage points lower than where it is now.

Ghost of Christmas past

One reason that many bullish traders are stubbornly refusing to throw in the towel is because they have fond memories of what happened around Christmas 2018, three years ago. You may recall that the stock market until then had been plunging, and on Christmas Eve came to the very brink of falling into an official bear market — defined as down at least 20%. But the market stepped back from jumping off that cliff, and began a powerful rally the first trading day after Christmas.

What these sanguine traders are forgetting is how bearish the mood had become by the time the market reversed course. As you can see from the accompanying chart, the HNNSI then fell to below minus 70%. It was lower at that time than 99% of all other daily readings since 2000.

The current mood on Wall Street has to become a lot more pessimistic before contrarians would be willing to entertain any parallels between today’s market and what transpired then.

This walk down memory lane also illustrates the need for contrarians to base their analysis on objective sentiment data as opposed to their subjective recollections. That’s because our memories play tricks on us. We rewrite history, telling ourselves that things couldn’t have felt that gloomy in December 2018, since it came in the middle of a bull market.

But the HNNSI doesn’t lie. The mood was extremely gloomy on Christmas Eve 2018.

If the market continues plunging as much as it has over the last couple of trading sessions, it’s entirely possible that the mood by the end of this week will be equally gloomy. But don’t jump the gun. Instead let the sentiment data guide you. We’re not there yet.

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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