Warning: This Market Indicator Will Make You Cringe

How do you feel about the stock market? Are you confident that stock prices are going to continue to rise? Or are you worried about a market pullback?

If you’ve been reading The Daily Edge for a while, your opinion may be a bit skewed. After all, we’ve been taking a fairly skeptical perspective on the broad market, and suggesting ways to protect your investments in case the bull trend runs out of steam.

But most investors aren’t taking such a balanced view of the markets.

And this week, I saw a statistic that caught my attention and made me worried. It’s a statistic that could mark the end of what has been one of the longest bull markets in history.

Let me explain…

The Optimistic State of Today’s Market

The results of a recent survey from the University of Michigan showed that an increasing number of investors believe with 100% certainty that the stock market will rise over the next year.

chart: investors are excessively optimistic

Not only is this level of optimism the highest in recent history, the way this survey is worded makes me cringe. These investors are one hundred percent SURE that the market will trade higher over the next year.

When was the last time you were “100 percent sure” of anything?

Ok, I’m 100% sure that my 4-year-old son loves me. There are still a few absolute certainties in the world today.

But the stock market is certainly not one of them. I’m 100 percent sure of that!

As a general rule, there’s nothing wrong with confidence, or with confident investors. But when confidence borders on arrogance, it’s a completely different story.

In looking at the startling results of this investor survey, there are two big questions I want you to ask yourself. The answer to these questions will help you decide how to better balance your retirement investments, and protect your wealth against uncertainty.

“Who Is Left to Buy?”

When you see statistics that tell you investors are excessively optimistic, it’s important to think about what these investors have already done.

Also, keep in mind that while only 15% of respondents said they were “one hundred percent certain” that the market is moving higher, these respondents still tell us a lot about the sentiment most investors have. While the other 85% of investors may not believe the market is absolutely certain to trade higher, we can agree that investors are generally very optimistic about the stock market’s prospects.

If the vast majority of investors believe there is a very good chance the market will trade higher, you can bet that these investors have already started buying shares of stock. After all, each of us wants to grow our wealth, and a rising stock market is a great way to do that!

Optimistic investors today have moved as much money as possible (or at the very least, as much money as they are comfortable with) into the stock market. And as these investors have steadily bought, the demand for stocks has naturally pushed the market higher.

But if these investors have already committed as much money as possible to the market, who is left to continue to buy stocks?

In order for the market to continue to trade higher, there needs to buying…. a lot of buying.

And the more cash investors plow into the stock market, the less cash is left on the sidelines. With investor sentiment now at extremely optimistic levels, I’m worried that there won’t be enough cash on the sidelines to continue to push markets higher.

“What Happens When Perceptions Change?”

A second question we have to ask about investors today, is what will happen when opinions shift?

Investors as a group tend to think that today’s environment will last forever.

During challenging times, investors worry that the market will never advance again. I remember during the dark days of 2008, investors I knew swore they would never buy stocks again. It just didn’t make sense to invest in something that could lose value so quickly.

Today, the mindset has changed 180 degrees. Investors believe markets will continue to move higher — with 100% certainty in many cases.

I can tell you that at some point, the majority of investors’ feelings on the market will shift. And when that happens, people who were formerly 100% committed to owning stocks, will swear off investing forever. And as they sell their positions, some popular stocks could lose the majority of their value.

This is simply the manic / depressive state of the market. And you can see these ebbs and flows if you look at a long-term chart of just about any stock market period.

chart: Shifts in sentiment

The problem is that the stock market “mania” has run its course for quite a long time. And the longer the market advances, the more confident and committed investors have become. With such devoted commitment to a long-term bull market, the resulting shift in sentiment (causing fickle investors to sell) could be very powerful…

Be Cautious, And Don’t Bet the Farm (Either Way)

While excessive bullish sentiment certainly spells danger for the market today, that doesn’t necessarily mean the stock market will trade lower immediately.

Economist John Maynard Keynes popularized the phrase “The market can remain irrational longer than you can remain solvent.”

In other words, just because investors are too optimistic today, doesn’t mean they will immediately start shifting to pessimistic tomorrow. The reversal could happen soon, or it could take a while to play out.

So I don’t recommend placing a huge bet that the market will fall right away. Just like I don’t recommend investing too much of your hard-earned wealth in the most widely-held stocks today.

Popular stocks like Facebook, Amazon and Netflix will likely bear the brunt of any sharp selloff. That’s because these are the names that “100% confident investors” are naturally gravitating to. And these are the stocks that these confident investors will sell once their confidence starts to falter.

So today, the best thing you can do to protect your wealth is to have a balanced approach to investing, and to shift away from these over-hyped shares of stock.

It’s much better to invest in solid blue-chip dividend-paying stocks that will still be valuable even if the market pulls back. And I also like the idea of moving some of your wealth into corporate bonds of solid companies that pay high yields, into gold and gold mining stocks, and into non-market investments such as real estate.

Smart investors know that you can never have 100% certainty in the stock market. And that the key to sustainable wealth is being prepared for many different potential outcomes.

Here’s to growing and protecting your wealth!

Zach Scheidt

Zach Scheidt
Editor, The Daily Edge
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