CHAPEL HILL, N.C. — The coronavirus is getting a bum rap as the cause of the stock market’s recent weakness.
That decline gathered steam on Monday, when the Dow Jones Industrial Average DJIA, +0.66% was at one point down more than 500 points.
It’s not that any of us should have sympathy for the virus, of course. But I don’t want to let the real culprit get off scot-free.
That real culprit is market sentiment: Short-term stock market timers, on balance, have been extraordinarily bullish for a couple of months now. Even a few days of such excessive bullishness would normally lead to market weakness, much less a few months of such exuberance. So conditions were ripe for a pullback.
If it weren’t the coronavirus, in other words, something else would have been the straw breaking the camel’s back.
Consider the average recommended stock-market exposure level among the several dozen short-term stock market timers I monitor on a daily basis. (This average exposure level is what is reflected in the Hulbert Stock Newsletter Sentiment Index, or HSNSI.) As you can see from the chart above, the HSNSI since October of last year has spent more days above the 90th percentile of past daily readings than below.
In fact, there has been no other three-month period since I started compiling the data in 2000 during which the average HSNSI level has been as high as it has been since October.
So, unless the role human psychology plays in the stock market has suddenly changed, a correction was overdue.
How big of a correction? Contrarians’ answer is that it depends on how traders react. It would be a good sign if they rush to the sidelines and then quickly jump onto the bearish bandwagon. In contrast, it would be a bad sign if they stubbornly hold onto their bullishness in the wake of the decline. In that case, contrarians would expect that an even deeper correction would be necessary to rebuild the Wall of Worry that would support a new leg upwards.
The usual qualifications apply, however. Most importantly, there are no guarantees. For example, the stock market in recent weeks continued higher even though market sentiment was unfavorable — as I had already pointed out in a late-November column. Furthermore, even if contrarian analysis turn out to be right in coming weeks, its forecasts apply only to the very short term, telling us little if anything about the market’s intermediate and longer-term trends.
The bottom line: You shouldn’t have been surprised by the stock market’s current weakness. On the contrary, had you been closely following market sentiment, you would have been expecting it — even before you had ever heard of the coronavirus.
Now read Michael Brush: Your 6-point plan to navigating a choppy stock market
