With the Dow trading at all-time highs around 16,000 and the market up 28% on a total return basis year to date, will stocks continue to set new records through the end of the year? Or might the market be overextended, setting the stage for a move down?
Here are five contrarian indicators—market data that is typically interpreted to go against the prevailing trend—that may help you determine which direction stocks could go. Several suggest some caution may be warranted.
1. S&P 500® vs. NYSE Margin Debt
Of bulls and bears
Both the S&P 500® Index and NYSE margin debt (a measure of the amount of leverage that investors are using) are at record levels. Margin debt has soared near $400 billion as investors have been willing to take on more risk with U.S. stocks at all-time highs. From a contrarian point of view, this could be a bearish indicator.
A contrarian could view high levels of stocks and margin debt as overconfidence, and low levels of stocks and margin debt as a sign that markets could go up. Additionally, some think peaks in margin debt could suggest potential peaks in stocks.
2. Put/call ratio
The put/call ratio measures the number of put options (securities that when purchased grant the owner the right to sell) that are being traded against the number of call options (securities that when purchased grant the owner the right to buy). As of November 21, 2013, the put/call ratio was 0.63, which is down sharply from a reading of 0.83 at the same time last year. This ratio has declined in recent days, which some contrarians might view as a bearish signal. However, it is well off of the lows of the year, near 0.45.
Many contrarians use this relationship as a way to judge the mood of the market. An increasing ratio may suggest investors are buying securities that they expect will decline in value, while a decreasing ratio would indicate the opposite. If the put/call ratio is increasing, contrarians might think investors are becoming overly pessimistic, and so they will assume it could be a time to buy. Frequently, those who use the put/call ratio will wait until it reaches a relatively extreme level. Currently, the put/call ratio is not near an extreme.
3. Sell-side consensus
The BofA Merrill Lynch sell-side indicator is a contrarian indicator that measures the average recommended equity allocation among Wall Street strategists. Wall Street experts known as sell-side strategists were very bearish at the beginning of 2013 (see the chart below). As a contrarian indicator, this translated to a bullish signal for stocks. The indicator has become less bullish throughout the year (a bearish signal for contrarians). It is worth noting that the October reading marks only the second monthly decline for the index since it hit an all-time low of 43.9 in July 2012. That could suggest the trend of strategists becoming less pessimistic (and thus, the contrarian indicator heading toward a bearish signal) could be weakening.
The thinking for this indicator among contrarians is that these sell-side analysts are generally wrong or behind the trend. Consequently, when these analysts are generally optimistic, a contrarian would sell. When they are pessimistic, a contrarian would buy.
4. Individual investor sentiment
The American Association of Individual Investors Investor Sentiment Survey measures the percentage of individual investors who are bullish, bearish, and neutral on the stock market over the next six months. For the week ending November 20, 2013, 34.4% of investors were bullish and 36.1% were neutral, while 29.5% were bearish. From a historical perspective, the percentage of bullish investors is slightly below the long-term average for this survey and is down sharply from previous weeks. Contrarians could view this as a bullish signal.
The thinking here is that the average investor is behind the trend. High or increasing levels of bullishness among individual investors might be considered a sell signal by contrarians. Conversely, high or increasing levels of bearishness could be interpreted as a buy signal.
5. Credit balances in brokerage accounts
Credit balances would be high if investors were in cash rather than stocks. To a contrarian, a decline in credit balances (i.e., investors are using cash to buy stocks) is considered bearish, while an increase (i.e., investors are selling stocks) would be bullish.
In the graph below, the circled area shows how credit balances are up sharply in 2013, and contrarians might view this as a bullish indicator. However, the most recent data does show a flattening out of credit balances, and may warrant further watching.
If you are a contrarian, you probably think that it’s best not to follow the herd. Several of these indicators suggest that there are some risks. It should be noted, however, that this list is far from comprehensive, and technical indicators such as these do not consider fundamental forces which appear solid.
You don’t have to always be a contrarian. There are other indicators, including the Treasury bill/eurodollar yield spread, margin balances in brokerage accounts, and Barron’s Confidence Index, that are used to follow what the so-called “smart money” investors are doing. Each of these indicators is relatively bullish at the moment.
It’s important to recognize that because there are a number of these types of indicators, they can (and frequently do) give conflicting signals. Determine for yourself which signals you think might be the most significant.