As analysts try to predict what market sentiment on Wall Street is going to look like in the future, they often turn to contrarian indicators.

Analysts use contrarian indicators to try to find extremes in market sentiment that can serve as potential turning points where bullish, or bearish, momentum will break out and start moving the opposite direction.

One contrarian indicator we like is the number of S&P 500 components that are trading above their 200-day simple moving average (SMA).

Here’s the idea behind the indicator.

Contrarian Indicators Explained

When a stock is trading above its 200-day SMA, it shows the stock is relatively strong. Conversely, when a stock is trading below its 200-day SMA, it shows the stock is relatively weak.

So, if you take all the stocks in the S&P 500 and calculate what percentage of them are trading above their 200-day SMA, you should get a pretty good idea of how bullish, or bearish, traders are.

The higher the percentage of stocks that are above their 200-day SMA, the more bullish traders are. The lower the percentage, the more bearish they are.

However, we’re talking about a contrarian indicator here. We want to know when things are getting too bullish or when they are getting too bearish, so we can get ready for a potential turnaround.

So, how does that work with this indicator?

Oftentimes when the indicator dips too low (anything below 20%), it suggests the pendulum has swung too far from bullish to bearish and that the market may be set for a bullish rebound.

You can see some great examples of this in Fig. 1 below.

Fig. 1 – Percentage of S&P 500 Stocks Above 200-Day Moving Average (S5TH)

Each time the percentage of stocks in the S&P 500 trading above their 200-day SMA dropped below 20% during the past 10 years, it signaled a coming rally in the S&P 500.

As you can see in the weekly chart of the S&P 500 in Fig. 2, the subsequent rally was particularly strong in 2020 after the indicator dropped to a dramatic low of just 1.98%.

Fig. 2 – Weekly Chart of S&P 500 (SPX)

So, how does the indicator do at identifying potential bearish turnarounds after the market gets too bullish?

In some instances, when the indicator climbs too high (anything above 80%), it suggests the pendulum has swung too far from bearish to bullish and that the market may be set for a bearish pullback. You can see some great examples of this in Fig. 3.

Fig. 3 – Percentage of S&P 500 Stocks Above 200-Day Moving Average (S5TH)

If you compare the times in Fig. 3 when the indicator moved above 80% in 2012, 2018 and 2020 (A, D and E) with the movement of the S&P 500 in Fig. 4 (A, D and E), you will see the indicator did a good job identifying moments when the market got too bullish and ended up experiencing a bearish correction.

Fig. 4 – Weekly Chart of S&P 500 (SPX)

But what about points B and C?

Why didn’t the market correct after the indicator rose above 80% those times?

Contrarian indicators, like this one, face one huge obstacle in the stock market: Stocks are designed to move higher in the long run. They skew bullish.

This phenomenon gets exacerbated when you are looking at an index like the S&P 500 because the index only keeps bullish stocks.

Any stocks that start to struggle too much are removed from the index and replaced with new bullish stocks, which makes it more difficult to identify when sentiment has become too bullish.

So, what about now? The indicator is at its highest point in more than a decade: 96.82%.

Is the S&P 500 doomed to turn lower?

We don’t think so.

We think point F is going to be more like points B and C.

Here’s why.

Why S&P 500 Isn’t Doomed Yet

Yes, the percentage of stocks in the S&P 500 that are above their 200-day moving average is incredibly high right now, but we believe part of that is due to the bearish pullback the market experienced in early 2020.

Sometimes stocks climb above their 200-day moving averages because they are in incredibly strong bullish uptrends.

However, they can also climb above them because they have recently plunged lower and pulled their 200-day moving average down with them.

Look at the chart of Southwest Airlines (NYSE:LUV) in Fig. 5 below, for example.

The stock isn’t trading any higher than it was in late 2018, but the price is above its 200-day SMA because the moving average got dragged lower by the stock’s pullback in 2020.

Fig. 5 – Daily Chart of Southwest Airlines (LUV)

It’s not so hard to climb above a 200-day SMA that has moved that low.

Many of the stocks in the S&P 500 are in this same situation. That means they still have plenty of room to see their prices move higher.

But that’s not all. This bullish rally has something else going for it.

We’re seeing abnormally low levels of short-selling on Wall Street at the moment, which removes some of the bearish pressure that would normally be applied to the market as it becomes increasingly bullish.

Looking at the S&P 500 short interest as a share of market cap in Fig. 6, you can see that it is at its lowest level in decades.

Fig. 6 – Short Interest Compared to S&P 500

Short sellers are understandably a little gun-shy right now after watching GameStop (NYSE:GME) shorts — along with a number of other short positions — get raked over the coals earlier this year.

We expect this hesitance to continue into the summer, but we don’t think it will last forever.

We’re actually looking at this unusually low level of short interest as another potential contrarian indicator.

If another bearish catalyst sends the S&P 500 lower in the future, we expect short sellers — who are currently stockpiling plenty of dry powder — to come back in force.

The Bottom Line

After the two-month rally that took the S&P 500 from just above 3,700 in early March to just below 4,200 in mid-April, the stock market is due for a break.

However, we expect this break will materialize in a consolidation range rather than an extreme bearish pullback.

This should leave plenty of opportunities for more bullish trades.

On the date of publication, John Jagerson & Wade Hansen did not hold (either directly or indirectly) any positions in the securities mentioned in this article.

John Jagerson & Wade Hansen are just two guys with a passion for helping investors gain confidence — and make bigger profits with options. In just 15 months, John & Wade achieved an amazing feat: 100 straight winners — making money on every single trade. If that sounds like a good strategy, go here to find out how they did it.