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Repairing the wall of worry

A week ago, I wrote about the fact that the market tends to experience 5% pullbacks quite often, noting that the most recent one is the sixth such pullback during the current two-year current bull market. One of the main points of that post was that regardless of the recent events in Japan and the Middle East/North Africa, the market was "overdue" for such a pullback, simply based on how far it had gone up since the last one.

That may seem odd to some, but the basic idea behind it is straightforward. Stock market activity is driven by three main components:

• Valuation (are stocks over/under-priced?);
• Monetary conditions (interest rates and changes to the money supply); and
• Psychology/Sentiment (are investors excessively bullish or bearish?).

Clearly, each of these pieces influences the others. And there are many ways to measure these various pieces, with various measures sometimes conflicting. So even knowing these are the three main drivers of the market doesn't simplify the task of predicting what the market will do next very much.

Getting back to the 5% pullback idea though, these pullbacks are important due to their impact on market sentiment. As the market goes higher and higher without any type of pullback or correction, there's a tendency for investors to become excessively optimistic. This shows up in all sorts of sentiment measures, such as bullish/bearish surveys and so forth.

You've probably heard the old market saying, "The market likes to climb a wall of worry." Well, when everyone gets bullish, there isn't much worry for the market to climb. Fortunately, this can be corrected rather quickly, as has been shown over the past three weeks or so.

Mark Hulbert wrote pair of articles for MarketWatch last week demonstrating just how rapidly the wall of worry has been rebuilt.

In the first, published last Tuesday, he noted that the market was then higher than before the March 11 Japanese earthquake. Yet sentiment among the market-timing newsletters he tracks had plummeted. Before the earthquake, these timers were collectively recommending that their readers be 49.1% invested in stocks. As of last Tuesday morning, that percentage was 15.8%.

Perhaps even more telling, the last time these timers were that cautious/bearish as a group was mid-September of last year. For those of you paying close attention, yes, that was precisely the point from which the recent uninterrupted rise in the market began. That was 1,500 Dow points ago. The fact that these timers were just as gloomy last week as they were six months ago, when the market was considerably lower, is a good thing. It indicates that wall of worry has been quickly rebuilt.

(It may seem odd that we consider these timers becoming more bearish as a positive thing. But as a group, they tend to be wrong. So this is a contrary indicator — when this group gets bearish, that's usually a good sign.)

Hulbert followed up his Tuesday article with another a day later that reported on how the behavior of corporate insiders had changed in recent weeks.

The idea behind using corporate insiders as an indicator is that they should know better than anyone what the true prospects are for their company. As a result, when they are selling heavily as a group, that's usually a bad sign for the market going forward. When they are buying heavily (or selling less heavily), that's usually a good sign. There are a number of caveats, but that's the gist of it.

So how have insiders responded to recent events? They've cut their selling by half. The last time the sell/buy ratio was as low as the most recent reading was...wait for it...last September.

Now, in the interest of full disclosure, I'm not overly impressed with either of these indicators and usually don't pay them much more than a passing glance. So I don't want anyone to get overly euphoric about them, in and of themselves.

Rather, I wanted to build on the idea from my post a week ago, showing why the market experiences (and needs) these relatively frequent small pullbacks. They serve as checks to the natural tendency for investors to become too optimistic as the market rises. These sharp pullbacks serve to shake out some of that excess bullishness. In so doing, they tend to prolong bull markets.

Recent events appear to have rebuilt the wall of worry in a relatively short amount of time. From a "what will the market do next" standpoint, while there are certainly no guarantees, knocking market sentiment reading down a few notches has to be seen as a positive development.

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