Here’s why the odds of a pullback are rising, and how to prepare for it now

Hey investors and traders, it’s time to override your emotions and get cautious on the markets. Otherwise, you might get laid low by a sharp pullback. The stock market is much more vulnerable to one now.

Crowd sentiment is very bullish and insiders are quite cautious. This is not a good combination. Here’s more detail.

1. Excessive sentiment

For subscribers of my stock letter Brush Up on Stocks I regularly track a dozen sentiment indicators. Right now, all of them are throwing off a bearish signal. This means they are measuring too much optimism. That sounds good, but it is actually bearish in the contrarian sense.

After all, the crowd is often wrong. And if nearly everyone is bullish, few people are left to convert to bullishness and buy your stocks. Another problem is that overconfident investors tend to be too easily surprised by bad news. They’re sure their new purchases can only go up. When stocks start to decline, they panic and sell. And the selling begets more selling. This makes the market vulnerable to a pullback.

Examples of excessive bullishness? Put buying (a bearish bet that stocks will decline) is minimal compared to call buying (a bullish bet). The Investors Intelligence Bull/Bear Ratio is near 3.8. For perspective, anything above four is the warning path, by how I interpret this signal. Above five is a very clear signal market weakness lies ahead. At least we are not there yet.

What does all this mean? Citi Research chief U.S. equity strategist Tobias Levkovich thinks the current level of bullish sentiment signals “a 100% probability of losing money in the coming twelve months” judging by historical patterns. “Indeed, we saw such levels back in early September, as well, right before a selloff in stocks,” he says. I was cautious ahead of the September pullback, too.

2. Cautious insiders

I’ve tracked insiders every day for 20 years. Ok that makes me a geek, but at least I have good feel for the tone of insider buying and selling. I think this is better than the standard quantitative measures you always see in the media, which weigh selling against buying. Those are useful, but they have shortcomings.

* They include the activity of money managers who are not company insiders, but still have to report activity because they have large positions. This muddies the signal since the majority of money managers lag the market. Who cares what they do? I’m not that interested.

* Other insider gauges try to “solve” this problem by eliminating all money managers. This is too blunt a tool, since it cuts out Warren Buffett and many money managers who actually are worth following. Indeed, this approach missed the sell signal that I caught in late August ahead of the September sell off, as you can see here. I have a short list of great buy side managers whose activities I track to help me make more accurate calls for my stock letter subscribers.

These two big-picture insider gauges also fail to capture which sectors insiders favor. That’s important. During March-June I was bullish on the markets and the economy because insiders heavily favored cyclical companies. Those outperform when the economy is improving. The insider preference for these names was a bullish economic signal for me, which many people missed. These two gauges also miss bullish insider patterns I look for, which amplify the insider signal.

I get why people are bullish

In my stock letter and in my MarketWatch column, I have been bullish since March (here, here and here, for example). I’m happy to see people join us, and push our stocks up. My logic has been that insiders were bullish in the right areas (cyclical stocks, materials, industrials and reopening plays); the virus wouldn’t last forever because vaccines would arrive; and the massive amount of stimulus put into the economy would create a very strong economy by the middle of next year. Now, many indicators confirm this view on the economy.

But the extreme sentiment and insider cautious tell me it is a time to pull back from being bullish now. Avoid buying stocks on margin. Trim big winners and dubious trades. Create a short list of stocks you want to buy in any weakness, and have cash on hand to do so.

Importantly: Don’t sell out of long-term positions to try to time short term moves, though. This is just a tactical call.

You can see an expanded version of this column at MarketWatch here.

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