How Wall Street behaves prior to market tops

By Mark Hulbert

A monthly review of recent Wall Street research

Sentiment at market tops is not the mirror opposite of sentiment at bottoms.

Traders should keep this in mind, since otherwise they may conclude that contrarian analysis has stopped working. For several months now the mood on Wall Street has been extremely optimistic-and yet the market has remained impressively strong.

That doesn't mean that contrarian analysis has stopped working, however. It's not unusual for Wall Street's mood to remain exuberant for some time prior to the market hitting a top.

Contrast that with sentiment's behavior in the days prior to market bottoms, when the collective mood darkens precipitously. Per standard contrarian analysis, that often signals that a market bottom is imminent. It's because of this that contrarians are able to boast several notable successes at identifying bottoms in close to real time.

The mistake many contrarians make is thinking that sentiment behaves in the symmetrically opposite way prior to tops. They therefore are tempted to issue sell signals at the first signs of excessive optimism.

The contrast between sentiment at tops and bottoms is illustrated in the accompanying chart. It plots the average recommended equity exposure level among a subset of several dozen short-term stock market timers monitored by my performance auditing firm. (This average exposure level is represented by the Hulbert Stock Newsletter Sentiment Index, or HSNSI). The data in the chart reflects all market tops and bottoms since 2002 in the calendar maintained by Ned Davis Research.

Notice first the HSNSI's steep drop in the trading sessions leading up to when the market hits a major bottom. On average over the month and a half prior to those bottoms, the HSNSI drops more than 40 percentage points. Over the same length of time prior to market tops, in contrast, the HSNSI rises much more slowly and aimlessly-with the average exposure level a little more than 10 percentage points higher than where it was six weeks previously.

The investment implications of this historical perspective contain both good and bad news for the current market. The good news is that recent extreme optimism doesn't mean a market top is necessarily just days away. The bad news is there's no escaping the high levels of optimism that prevails on Wall Street-which in turn suggests strongly that a market top can't be postponed indefinitely. Eventually the laws of gravity prevail.

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.

-Mark Hulbert

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