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Mark Hulbert

Watch out for a correction -- or worse

8/8/12 12:01 AM ET (MarketWatch)Print

CHAPEL HILL, N.C. (MarketWatch) -- Odds of a stock market correction are now quite elevated.

That's because stock market timers are now more bullish than they were at the May 1 bull market high, even though the market averages are still slightly below those previous highs. This is not good from a contrarian point of view.

Consider the average recommended stock market exposure level of the shortest-term market timers monitored by the Hulbert Financial Digest (as measured by the Hulbert Stock Newsletter Sentiment Index, or HSNSI). This average currently stands at 50%.

At the May 1 bull market high, in contrast, this average stood at 42%. The Dow Jones Industrial Average (DJIA) at that high was 110 points higher than its recent close. This contrast does not bode well for the stock market's near-term future.

I would of course urge you at any time to give contrarian analysis serious consideration. But an added reason to do so now is that this approach did a particularly good job of navigating the May-June correction.

Consider the conclusions contrarian analysis reached at the following points along the way:

On May 9, just eight days after the May 1 bull market peak, I reported that a major correction -- a drop in the market averages in excess of 10% -- was "unlikely" because many of the timers who were bullish on May 1 had quickly run for the exits. At the correction's lowest point, of course, which came on June 4, the Dow Jones Industrial Average on a closing basis had dropped just 8.9%. (Read my May 9 column, "Major correction unlikely.")

On June 5, the day after the day of the exact low of the correction that had begun on May 1, I reported that "a tradeable low is close at hand." That conclusion was based on the excessive levels of pessimism that then prevailed -- which, by some measures, were at levels not seen in nearly two years. (Read my Jun. 5 column, "Correction close to being over.")

On Jun. 15, when the Dow stood at nearly 12,800, almost 700 points higher than where it had been at the June 4 low, I reported that the rally still had room to run, according to contrarian analysis. (Read my Jun. 15 column, "Wall of worry remains quite strong.")

To be sure, contrarian analysis began to turn cautious in early July, prematurely so. Followers of this approach therefore will have missed some or all of the last 200 Dow points.

Just as was the case early on during the correction that began in early May, a key thing to watch whenever the market does begin to pull back will be how quickly the bulls run for the exits. If they are as quick to do so this time around as they were three months ago, then contrarian analysis once again will forecast only a modest pullback.

But if the bullish timers stubbornly hold on to their bullishness in the face of any pullback, then there will be greater odds of a more major correction -- since only in that way will the veritable Wall of Worry get rebuilt.