Things are going pretty well for the stock market these days. The promise of another flood of easy money from the Federal Reserve and political gridlock in Washington upon the victory of the Republicans has boosted share prices by nearly 13% since late August.
But now, with confidence so high, the bulls are vulnerable to disappointment and a chaotic, soul-wrenching selloff in risky assets plummet out of the low-volatility perch that’s been established over the past two weeks.
According to the technical analysis team at Barclays Capital, stock market sentiment has reached levels not seen since 2007 — before the housing-fueled bull market collapsed. Going further back, sentiment last reached current levels in late 2000 — just before the dot-com bubble imploded. Not exactly good company.
Their proprietary indicator just hit a high of 93; up from a low 10 this summer. At the bear market trough in March 2009, this indicator hit a low of just 2.
With sentiment so stretched and expectations so high, it won’t take much to cause a bout of profit taking and panic selling. Surprisingly, the catalyst could be the Republican takeover of the House of Representatives. Shocked? Well, it’s happened once before.
The Barclays team also points out that — with the likely takeover of the House by Republicans seen as a positive factor by investors — stocks could move lower in the days following the election. In fact, as shown in the charts above, this is exactly what happened back in 1994 when the Republicans won the house and stymied President Clinton’s agenda. If the pattern holds, we could be looking at a return to the February/July lows.
Separately, the American Association of Individual Investors survey of bulls vs. bears has reached new highs. You can see this in the chart above — which shows the 4-week average of the AAII Bull Ratio. This is calculated based on the number of bullish survey respondents as a percentage of all respondents. The measure, relative to recent volatility, has moved to levels not seen since 2003.
Obviously, when so many people think the market can only go up — the market gods make sure the opposite happens. With just about every asset class looking extended at current levels, the only instrument that looks ready for a rise is volatility — as represented by the CBOE Volatility Index ($VIX). As stocks have stalled, the VIX has gained nearly 13% this week. You can play this with the iPath S&P 500 VIX Short-Term Futures ETN (NYSE: VXX).
Disclosure: The author does not own or control a position in any company mentioned.
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