The stock market just experienced its worst week of 2019, falling from record all-time highs.
An important indicator we follow, the Daily Sentiment Index (DSI), hit the critical 90% bullish level a few weeks ago for the NASDAQ and S&P 500 Index, warning of an impending trend reversal in prices. While stocks didn’t necessarily have to suddenly reverse course at that time, it served as an early warning signal. That warning proved prescient. Caution is the prudent course of action here.
On July 12, the NASDAQ DSI (trade-futures.com) rose to 93% bulls and the S&P 500 DSI pushed past 90% bulls, both near the top end of their historic range.
We’ve often discussed sentiment readings and “crowded” trades and how they often mark turning points for a security and/or the market as a whole. As a reminder, a "crowded" trade is one where too many investors are piling in on the “buy” or “sell” side (we’re currently seeing it on the “buy” side).
The Daily Sentiment Index (DSI) is a contrary indicator. The DSI provides an "emotional" indicator of market behavior.
The recent stock market rally started on June 3rd, after the indices fell by about -8% in May. At that time, the DSI for the NASDAQ and S&P 500 was about 9% bulls, a bearish extreme.
So, we’ve had a complete flip in sentiment, from a bearish to a bullish extreme. A few other sentiment indicators, including the put/call ratio, have flashed red.
Most pundits are expecting a 3-5% stock market correction which may very well happen, however, there is a possibility that this pullback morphs into something more significant. Our worst-case scenario is that the market breaks below its Christmas lows – that’s a long way down from current levels. Virtually no one expects a downside move of that magnitude.
The sustained period of exuberance we've just gone through means that it will take more than just a day or two of market drops to work off the excess optimism. Don't forget - the market has a way of surprising investors. You should be prepared.
Disclosure: George Kiraly Jr., CFP®, MBA is the Founder & Chief Investment Officer of LodeStar Advisory Group, LLC, an independent Registered Investment Adviser located in Short Hills, New Jersey. George Kiraly, LodeStar Advisory Group, and/or its clients may hold positions in the ETFs, mutual funds and/or any investment asset mentioned above. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. The above commentary does not constitute individual investment advice. The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. This material represents an assessment of the market environment at a specific time and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any security in particular.