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State of the market: With Dow at a record high, is it time to look for the pullback?

Now that the DJIA has reached a new all-time high and the S&P 500 is getting close to doing so as well, it seems that the big topic in the press these days is picking the top. While history shows that new highs tend to lead to more new highs, the problem is the last time the Dow reached the Promised Land in 2007, the bears then started mauling everything in sight. And since 40%+ declines tend to stick with people for a while, everybody and your grandmother are looking for the top right now. In short, nobody wants to get fooled again.

Frankly, I can't blame anyone for being wary of the market at this juncture. After all, the market has taken at least one nasty spill during each and every calendar year since 2007. Therefore, anyone looking for something bad to happen in the near future does have history on their side. And since the drivers of the recent corrections (Europe and Washington) haven't exactly gone away, it isn't surprising that folks might be getting a little nervous at this stage of the game.

Normally, this is where I'd climb up on my soapbox and start preaching about staying in tune with what is happening in the market instead of listening to the guru's and their crystal ball-based prognostications. But since I gave that sermon as recently as yesterday, I should probably give it a rest for a while.

So, since everyone seems to be so sure that stocks are about to take a dive, this morning I thought I'd offer up an indicator that does a pretty good job of 'calling' big declines. And no, I'm not going to pitch you on my market-model approach again. But I will tell you that the indicator I'm going to describe is one of the inputs to our Market Environment Model.

But first, a couple caveats: The first is I would never suggest anyone use a single indicator to make any type of investment decision. Second, market “sentiment” indicators can be more than a little tricky and I do not have time or space this morning to do a thorough explanation of the ins and outs. However, I think this one indicator is worth your time. So let's get started.

Ned Davis is famous for saying, “Beware of the crowd at extremes.” The idea is that when everyone is bullish (or bearish) they have already made their move in the market. This naturally leads to the question of: who is left to buy (or sell)? I'm guessing most everyone in the game these days has heard some version of this concept. And frankly, this in and of itself makes sentiment indicators less valuable – especially on a short-term basis.

But what you may not have heard about the idea of trying to gauge investor sentiment is that to be really effective, one needs to wait for sentiment to reverse after it has reached an extreme. You see, an extreme sentiment reading by itself isn't a sell signal (extreme readings can and often do become more extreme!). However, if a move is strong enough and lasts long enough for the sentiment indicators first reach an extreme and then start to reverse – now we've got something. In short, this is an indication that a move has gotten very crowded and is starting to go the other way.

Dave Moenning

David Moenning is Chief Investment Officer at Heritage Capital Management, a Chicago-based registered investment advisory firm. Mr. Moenning began his investment career in 1980 and formed Heritage Capital in 1989. Dave’s firm focuses on “active management” and focuses on managing market risk on a daily basis. Dave is also the proprietor of StateoftheMarkets.com, which provides free and subscription-based portfolio services. Mr. Moenning is the 2013-14 President of NAAIM (National Association of Active Investment Managers) an organization dedicated to active management strategies. Follow Dave on Twitter at @StateDave.