Monday, April 6, 2015 8:27 PM EDT
Strike 1... "Massive overvaluation"
Strike 2... "dramatic decoupling of markets from economic productivity"
and finally, Strike 3... "near-record extreme market sentiment"
As illustrated, the stock market has typically struggled once the R-squared (investor sentiment) has risen above 90%.
While the 13 previous cautionary signals since 1900 suggesting investor sentiment was too high have not been perfect, they have proved to be fairly good warning signs. For eight of the 13 signals, the stock market either immediately or fairly soon suffered a bear market (i.e., 1906, 1929, 1937, 1946, 1956, 1965, 1987, and 2007).
After both the 1926 and 1998 signals, the stock market eventually suffered a correction and after both the 1952 and 1994 signals, the stock market was essentially flat and volatile during the subsequent two years. Only the caution suggested by the 2003 signal proved inappropriate.
Finally, the timing of a few signals were remarkably clairvoyant (i.e., September 1929, September 1987, and December 2007).
* * *
Since 1900, only when investor sentiment is above 90% has the median one-year forward percent change in the stock market been negative.
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