The Greatest Complacency of the 21st Century

Many of our readers know intuitively that their neighbors and friends have become complacent about the world around them, but they don’t know how to prove it.

Today, I’ll show you two ways to do just that.

The key is that rising equity prices usually lead to an increase in stock market optimism, while falling prices generate stock market pessimism.

That alone is no justification for bearish or bullish strategies — until it reaches an extreme.

So the questions are: How do you measure this optimism or pessimism? And how do you know when it’s at an extreme level?

Right now, I’d like to focus on two measures in particular …

Mutual Fund Cash Levels

The average cash allocation of mutual fund managers is one of the most important sentiment indicators available — and for good reason: Forty percent of all U.S. stocks are held by mutual funds. So their buying and selling can easily move the market.

What’s especially remarkable is that fund managers are as prone to the herding instinct as any other group, which leads to an interesting pattern in their investment behavior:

Mutual fund managers almost invariably hold relatively high cash levels near market bottoms, and relatively low cash levels in the vicinity of important market tops.

Go back to March 2000, for example, near the top of the tech stock bubble. Precisely when they should have been taking profits off the table, mutual fund managers loaded up with stocks and ran their average cash levels down to 3.7 percent. For them and their shareholders, it was a disaster. For astute investors, however, it was a blatant and very TIMELY sell signal!

But now look:

Mutual fund cash levels are even lower than they were in March of 2000!

In fact, according to the Investment Company Institute, mutual fund cash levels are currently at an extremely low 3.5 percent. They have been that low just twice before:

• First, in the summer of 2007, at the climax of the 2003-2007 cyclical bull market.
• Second, in March/April 2010 right before the flash crash of May 6, which marked the beginning of a 17 percent market correction.

What’s most remarkable is that, as you can see in the chart below, cash levels have been very low for more than a year. This tells us that the only thing driving the market higher is the Fed, and we don’t doubt their ability to continue their money pumping. But the history of this indicator suggests that the next vicious bear market may be lurking around the corner.

Another indicator I closely follow is …

Investors Intelligence Advisor Sentiment

Investment newsletter editors play an important role in influencing and driving investor sentiment; and Investors Intelligence has developed a relatively reliable sentiment indicator to track them.

Here, too, a pattern is clear:

Compared to mutual fund editors, newsletter writers seem to be more flexible, adapting more rapidly to changing market conditions. So when they’re overly bullish as a group, it often has only short- to medium-term bearish implications.

But still, long stretches of extreme bullish sentiment as measured by this indicator has often marked major tops.

As you can see in the second panel on the chart below a high degree of bullishness has been persistent for nearly four months. And the trigger line for a bearish signal — more than 55 percent bulls — has been broken.

This is another clear warning sign that a larger correction is overdue. Moreover, despite the stock market correction of the past few weeks, bullish sentiment has prevailed. That’s very unusual, and I think it’s another confirmation of the bearish signal!

Indeed, we see little or no angst even in the wake of ominous news coming out of Japan, North Africa, and the Middle East!

That’s complacency par excellence — historically a sign of an imminent stock market top.

If you are looking to profit from falling stock markets, I’d say that a decline in the Nasdaq 100 is the most probable. So you might consider ProShares Short QQQ ETF (PSQ) in the $33-$34 range. This inverse ETF is designed to rise 1 percent for every 1 percent drop in the NASDAQ-100 Index.

Best wishes,

Claus