History Flashes A Dangerous Warning To U.S. Stock Bulls

Some great charts on sentiment this week from Meb Faber courtesy of Leuthold's Green Book. The first chart shows the Investors's Intelligence average annual sentiment toward U.S. stocks. Essentially, a higher reading means there are more people positive on the near term direction of U.S. stocks. Last year was the highest reading in 34 years.

The market stayed ridiculously euphoric throughout the entire year, even during the (brief) dips in prices. In years past bears would enter the survey when prices dipped thinking the market may have finally reached a cyclical peak. Those bears completely disappeared this year believing every dip was only a better chance to buy more U.S. stocks with leverage if possible. I should note they have all been right so far.

The following chart shows the year after returns for the top 10 highest annual sentiment readings. The average return was 0.1%. You'll notice that while there were many steep declines, there were also some years with major gains.

On the flip side you have the 10 years with the lowest sentiment readings and what transpired the following year. You can see the average returns are now 17.4% with only one down year. It would appear less risky based on historical evidence to enter a market when everyone hates the asset class.

This is the reason I heavily weight sentiment when making personal investment decisions. I like to buy fundamentally strong assets after a price decline when sentiment is low. Often times that means I am buying assets which are still falling in price. I cannot, nor will I ever be able to, time a bottom perfectly in any asset class. I'm not a trend follower or market technician, which means I spend a lot of time on the sidelines watching people get rich on paper chasing overpriced assets higher and a lot of time buying things as they're falling in price and people are telling me I'm insane.

I consider myself fairly early into my investment life so I'll let you know how this strategy works once it has about 40 years to develop. Fortunately, I'm not blindly guessing. This is the only strategy I'm come across that works over the long run from the thousands of hours I've spent studying the financial markets, successful long term investors and market history.

Almost everyone believes they will get out at the top of the current U.S. stock market bubble. I'm betting that most do not. The question is, when the real sell-off finally begins, at what point in the decline will psychology change from "buy the dip" to "uh-oh." As always, I'll be fascinated to watch it take place from the boring bleachers.

For more see: Average Valuations Show U.S. Stocks More Dangerous Than 1929 Peak