Recent Gains in the Stock Market Have Caused Investors to Be More Bullish Than They Should Be

Savvy investors often become cautious when market sentiment data indicates excessive bullishness among the crowd. This is because such high levels of optimism can suggest that there are fewer potential buyers left to sustain the rally, potentially serving as a contrarian indicator for a sell-off.

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However, the current situation is slightly different, according to Jeff deGraaf, chairman and head of technical research at Renaissance Macro. Instead of extreme bullish sentiment signaling an imminent market downturn, investors are displaying a higher-than-typical level of optimism relative to the stock market gains over the past 13 weeks. While this doesn’t necessarily predict an immediate sell-off, it does suggest that near-term returns may be less impressive.

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DeGraaf noted, “It’s not so much that sentiment is uncomfortably elevated, it’s that bulls are much higher than they ‘should be’ given returns over the last 13 weeks.” Essentially, the level of bullishness is disproportionate to the recent market performance.

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To understand this, deGraaf explains that sentiment is driven by returns, not the other way around. Therefore, it’s possible to quantify the “appropriate” level of bullishness based on historical performance data.

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For instance, with the S&P 500 index (SPX) achieving returns of about 5% over the past 13 weeks, historical data suggests that the percentage of bullish investors in the weekly Investors Intelligence survey should be below 50%. Currently, however, bullish sentiment is closer to 60%, indicating an overly optimistic attitude compared to what the recent returns would typically justify.

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DeGraaf highlights that historically, when bullish sentiment exceeds what would be expected based on returns, subsequent market performance tends to be below average, though not necessarily negative. This implies that while the market may not experience a significant decline, the potential for exceptional returns in the near term is limited when bullish sentiment is excessively high.

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In summary, while current investor sentiment isn’t signaling an imminent market sell-off, the elevated level of optimism compared to recent returns suggests that near-term gains may be modest. Investors should be mindful of this dynamic, understanding that historical data points to below-average returns when bullish sentiment is disproportionately high relative to market performance.

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