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The Strongest Case for a Stock Market Rally Right Now

By Ian Davis
Thursday, January 24, 2008

You have to go back 17 years to find an investing public more pessimistic than it is today...
 
Right now, 75% of individual investors believe the stock market will be lower in six months. Sentiment hasn't been this low since October 1990 – the end of the last bear market in real estate. This was also a notably tough time for the stock market, which was down 11.5% on the year.
 
This may sound like bad news for people heavily invested in stocks, but it could be a great short-term buying opportunity. Following the pessimism in October 1990, the market rallied 4.4% over the next month, and 9.5% over the next two months.
 
You see, extreme pessimism often precedes short-term rallies in the stock market. However, buying simply because individuals are pessimistic often gets you into a trade too early. The best strategy is to wait until individuals are extremely pessimistic... but becoming less so.
 
The chart below compares the S&P 500 index to the sentiment survey released by the American Association of Individual Investors (AAII). In the survey, the AAII asks its members, "Where do you think the market will be in six months?"
 
They are given three choices to answer the question: bullish, bearish, and neutral. The AAII "Percent Bull Ratio" is the number of investors who are bullish compared to the total number of investors who weren't neutral – i.e. bullish/(bullish+bearish).
 
Individual Investors – A Good Contrarian Signal
 
 
As you can see, over the last four years, pessimism extremes have often corresponded with good buying opportunities.
 
Let's look at the numbers... The table below singles out 11 instances of extreme pessimism and compares the S&P 500's performance four weeks after those occurrences to its average four-week performance from 2004 to today.
 
S&P 500 Return
After Pessimism
Extreme
All Periods
Average 4-week return
2.0%
1.2%
Number of occurrences
11
52
Winning percentage
90.9%
69.2%
 
"Winning percentage" refers to the percentage of time the stock market rose over the four-week period. So, 69% of the time, the market closed higher than it did four weeks earlier.
 
But the market closed higher 90.9% of time four weeks after instances of extreme pessimism.
 
Granted, you can't use the past as a guide to blindly make trading decisions. But the conclusion is what any good contrarian would expect: Investors are extremely pessimistic right now... which means a rally is on the way.
 
Good investing,
 
Ian Davis




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Market Watch
Symbol Price
Change
52-Wk
S&P 500 1221.53 +1.3% +10.1%
Oil 38.31 +1.4% -0.6%
Gold 138.07 +2.1% +16.3%
Silver 28.60 +2.4% +53.6%
US-Dollar 80.67 -0.8% +8.1%
Euro 1.32 +0.6% -12.1%
Volatility 18.01 -7.1% -19.8%
Gold Stocks 581.56 +3.0% +17.0%
10-Year Yield 3.02 +0.7% -10.7%

World ETFs
Symbol Price
Change
52-Wk
USA 122.89 +0.3% +11.3%
Canada 30.50 +0.2% +16.2%
Russia 21.94 +1.4% +18.1%
India 37.85 +0.3% +22.3%
Israel 16.69 +1.3% +10.8%
Japan 10.64 +0.6% +6.5%
Singapore 13.73 -1.1% +18.8%
Taiwan 14.78 +0.4% +19.2%
S. Korea 57.31 +1.3% +23.4%
S. Africa 71.87 +1.4% +28.2%
China 44.42 -1.4% -0.6%
Lat.America 53.17 +0.7% +8.4%

Sector ETFs
Symbol Price
Change
52-Wk
Oil Service 137.59 +1.0% +18.9%
Big Pharma 64.14 +0.0% -3.2%
Internet 72.07 -0.1% +23.4%
Semis 16.22 +1.2% +29.4%
Utilities 31.28 +0.2% +1.5%
Defense 18.52 +0.1% +10.6%
Nanotech 10.03 +0.4% +1.6%
Alt. Energy 10.08 +1.3% -3.3%
Water 18.49 +1.0% +14.5%
Insurance 16.14 +0.4% +21.1%
Biotech 20.54 -0.2% +28.1%
Retail 19.70 +0.3% +30.2%
Software 24.79 +0.8% +25.9%
Big Tech 53.87 +0.3% +22.7%
Construction 13.10 +0.9% +15.7%
Media 13.64 +0.5% +26.0%
Consumer Svcs 67.39 +0.2% +24.5%
Financials 55.04 +0.3% +7.4%
Health Care 64.30 +0.1% +2.0%
Industrials 63.54 +0.5% +21.0%
Basic Mat 74.35 +1.1% +25.3%
Real Estate 55.32 +0.1% +25.0%
Transportation 91.77 +0.7% +26.9%
Telecom 22.59 +0.5% +17.8%