Yet another piece of the investor sentiment puzzle is falling into place to support a sizeable rally in the US stock market. I’m referring to an index that measures investor confidence that any market dip will soon be followed by a recovery. The index, called the “US Buy-on-Dips Confidence Index,” was created two decades ago by Robert Shiller of Yale University. It is based on a monthly survey asking investors to guess the direction of the market the day after a 3% drop in the market.
My analysis of the data indicates that the index has a contrarian meaning. That is, high values - high confidence that any market decline will be followed by a rapid recovery – is a bad sign. Low values, on the other hand, are bullish.
Last summer, the index was below 7% of all other monthly readings since Shiller began this survey in the 1990s. While that in itself is low enough to impress opponents, it’s also encouraging that the index hasn’t risen since then. The normal pattern is for the bullishness to jump when the market starts to rise. But the index is currently at only the 20th percentile of the historical distribution.
In fact, the latest reading is even lower than the one recorded in March 2020, at the low end of the waterfall drop that accompanied the initial lockdowns of the COVID-19 pandemic. But for the summer of 2022, you have to go back to late 2018 and early 2019 to find another time when the Buy-on-Dips Confidence Index was lower than where it stands today. Those months coincided with the low of the 19%+ correction (bear market) caused by the Fed’s rate hike cycle in late 2018.
The index’s highest in recent years came in August 2021, when it rose to the 91st percentile of the historical distribution. As if we need to be reminded that that came just two months before the top of the secondary market and four months before the broad market peaked.
These two are just data points. More detailed analysis is shown in the table below, based on monthly data for the US Buy-on-Dips Confidence Index from the past two decades.
Buy-on-Dips Confidence Index level is in the… Average S&P 500 profit over the next month Average S&P 500 profit over the next 3 months Average S&P 500 profit over the next 6 months Lowest 25% of historical values +0, 7% +2.4% +6.3% Highest 25% of historical readings -0.4% +0.3% +2.1%
While these differences in average returns are statistically significant, it is important to emphasize that there are no guarantees. After all, sentiment is not the only factor that moves the market.
Moreover, even if a strong rally comes out, we cannot know if it will be the start of another bull market or just a bear market rally. The answer will depend, at least in part, on how slowly or quickly investors regain confidence that market dips will soon be followed by a recovery. Right now, a contrarian analysis suggests a strong rally is likely in the coming weeks.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings keeps investment newsletters that pay a fixed fee to be audited. He can be reached at [email protected]
Also read: How Powell Turned Away From the Fed’s Dovish Message and Soiled the Markets?
Plus: why inflation is likely to remain sky-high no matter which side wins the midterms