Doom and Gloom

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MARK HULBERT
Air sickness

Commentary: Market's volatility making timers skittish; that's bullish

By Mark Hulbert, MarketWatch

Last Update: 12:01 AM ET Oct 26, 2007

ANNANDALE, Va. (MarketWatch) -- Earlier this month, I used a rodeo analogy to describe how volatility in bull markets will scare investors away from remaining invested.

I had written then that "a bull market... can be thought of as a bucking bronco in a rodeo, trying its darndest to throw everyone off its back on the way to the other side of the ring." See Oct. 3 column

But I can't say that I imagined the extraordinary volatility we've seen in recent sessions. The Dow Jones Industrial Average ($INDU) experienced swings of several hundred points in each direction on both Wednesday and Thursday of this week. Though the market ended the day Thursday at more or less the same level it did on Tuesday, investors who held on for the ride are probably feeling a distinct need for an air sickness bag.

The effect of this is easily seen among the short-term market timing newsletters I track, many of which have reacted to the market's volatility by throwing in the towel. They just can't take the wild ride.

Consider the latest readings of the Hulbert Stock Newsletter Sentiment Index (HSNSI), which reflects the average recommended equity exposure among a subset of these timers. As of Thursday's close, the HSNSI stood at just 7.7%. In other words, the average short-term market timing newsletter is now almost completely out of the stock market.

What I find particularly noteworthy is that this most recent level for the HSNSI is nearly 26 percentage points lower than where this sentiment index stood at last Friday's close. That was the day in which the Dow suffered a mini crash, falling 367 points.

Yet the Dow closed Thursday night some 150 points higher than then. In other words, the average short-term market timing newsletter has reacted to a rising stock market by becoming markedly less invested in equities.

That's bullish, from a contrarian perspective. If last week's big drop constituted the beginning of a major bear market, and if sentiment trends adhered to the historical pattern, then advisers would have increased their exposure this week.

But they haven't, and that is why I continue to rate the sentiment conditions as positive for this stock market.

To be sure, I reached the same conclusion exactly one week ago, in a column published early in the morning of last Friday's mini-crash. So let me repeat the statistical qualifications I have stressed in some earlier columns:

- Our econometric analysis of the sentiment data over the last two decades shows that it does a credible job of forecasting the relative probabilities of market rallies and declines. In some econometric tests that we've run, sentiment variables such as the HSNSI are able to explain as much as a third of the market's subsequent three-month returns. (For the statisticians among you: The r-squared in some regressions is as high as 0.33.)

- That is quite impressive from a statistical point of view, since most of the indicators that get bandied about on Wall Street are unable to stand up to any statistical scrutiny whatsoever. Nevertheless, notice that - even so - sentiment can not explain two-thirds of the stock market's ups and downs.

- This is just another way of saying that sentiment is not the only thing that makes the stock market tick. So contrarian analysis should be just one tool in your investment arsenal.

- This in turn implies that it is useful to have lots of tools in our investment arsenal.

- Notice also that contrarian analysis is at best a shorter-term tool. To the extent it can tell you anything, it is primarily about how the market will perform over the next couple of months. It won't help you guess where the stock market will be when you retire several decades from now.

The bottom line? Anything can happen. But, from the perspective of a contrarian analysis of sentiment among investment newsletters, odds continue to favor the bulls.

Mark Hulbert is the founder of Hulbert Financial Digest in Annandale, Va. He has been tracking the advice of more than 160 financial newsletters since 1980.

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