Are investors too bullish? … what we can learn from the 200-day moving average … how our technical experts, John Jagerson and Wade Hansen, are sizing up today’s bull/bear tug-of-war

Are investors too bullish right now?

If you’ve been in the market long enough, you’ve probably noticed an interesting dynamic…

When too many investors share the same market belief (whether it’s bullish or bearish), the opposite move often plays out.

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Today, traders are incredibly bullish. The indicator we’ll discuss momentarily sits at its highest point in more than a decade.

On one hand, that’s great – we don’t want a bunch of gloom-and-doom traders who are pulling money out of the market.

But on the other hand, are too many bullish investors actually a warning sign?

Today, we’re going to answer this with the help of our technical experts, John Jagerson and Wade Hansen.

For newer Digest readers, John and Wade are the experts behind Strategic Trader. It’s an elite options service in which they combine insightful technical and fundamental analysis with market history, to take advantage of all sorts of market conditions.

To identify profitable trade set-ups, they analyze a variety of indicators, ratios, and chart patterns. This helps provide clues about where the market and specific stocks are likely headed.

In their update from Wednesday, John and Wade tackled an important indicator for evaluating today’s market.

From John and Wade:

As analysts try to predict what market sentiment on Wall Street is going to look like in the future, they often turn to contrarian indicators.

Analysts use contrarian indicators to try to find extremes in market sentiment that can serve as potential turning points where bullish, or bearish, momentum will break out and start moving the opposite direction.

One contrarian indicator we like is the number of S&P 500 components that are trading above their 200-day simple moving average (SMA).

Today, we’ll dive into the “200-day” as it’s often called, and find out what it’s suggesting for market direction.

Let’s jump in.

***Is the 200-day reason to be bullish or bearish?

Let’s start by better understanding the 200-day moving average, and how to interpret it.

From Wednesday’s Strategic Trader update:

When a stock is trading above its 200-day SMA, it shows the stock is relatively strong. Conversely, when a stock is trading below its 200-day SMA, it shows the stock is relatively weak.

So, if you take all the stocks in the S&P 500 and calculate what percentage of them are trading above their 200-day SMA, you should get a pretty good idea of how bullish, or bearish, traders are.

The higher the percentage of stocks that are above their 200-day SMA, the more bullish traders are. The lower the percentage, the more bearish they are.

Now, so far, this is pretty intuitive. So, how, exactly, is this a contrarian indicator?

That ties back to the question that opened today’s Digest – are traders too bullish?

Back to John and Wade:

We want to know when things are getting too bullish or when they are getting too bearish so we can get ready for a potential turnaround.

So, how does that work with this indicator?

Oftentimes when the indicator dips too low (anything below 20%), it suggests the pendulum has swung too far from bullish to bearish and that the market may be set for a bullish rebound.

You can see some great examples of this in Fig. 1 below

Fig. 1 – Percentage of S&P 500 Stocks Above 200-Day Moving Average (S5TH) — Chart Source: TradingView

John and Wade note how each time the percentage of stocks in the S&P 500 trading above their 200-day SMA dropped below 20% during the past 10 years, it signaled a coming rally in the S&P 500.

To drive this point home, they highlight what happened in the S&P last year.

The indicator plunged to a low of just 1.98%… and then proceeded to stage a massive rally.

Fig. 2 – Weekly Chart of S&P 500 (SPX) — Chart Source: TradingView

***How well does this indicator identify bearish turnarounds after the market gets too bullish?

Back to the update:

In some instances, when the indicator climbs too high (anything above 80%), it suggests the pendulum has swung too far from bearish to bullish and that the market may be set for a bearish pullback.

You can see some great examples of this in Fig. 3.

Fig. 3 – Percentage of S&P 500 Stocks Above 200-Day Moving Average (S5TH) — Chart Source: TradingView

If you compare the times in Fig. 3 when the indicator moved above 80% in 2012, 2018 and 2020 (A, D and E) with the movement of the S&P 500 in Fig. 4 (A, D and E), you will see the indicator did a good job identifying moments when the market got too bullish and ended up experiencing a bearish correction.

Fig. 4 – Weekly Chart of S&P 500 (SPX) — Chart Source: TradingView

Now, points “A,” “D,” and “E” represent just a handful of the times in which the indicator moved above 80%.

What about points “B” and “C”? As you can see above, the market kept cruising higher during those periods without suffering a correction.

John and Wade tell us the reason for this is because stocks are designed to move higher in the long run – they skew toward the bullish side. And this is a big headwind for contrarian indicators.

So, we can’t look at this indicator and expect it to work perfectly every time – even though it has a solid track record.

***What is the indicator telling us today? And what should investors do about it?

Here’s where things get more interesting.

Back to John and Wade:

The indicator is at its highest point in more than a decade: 96.82%.

Is the S&P 500 doomed to turn lower?

We don’t think so.

We think point F is going to be more like points B and C.

Here’s why…

Yes, the percentage of stocks in the S&P 500 that are above their 200-day moving average is incredibly high right now, but we believe part of that is due to the bearish pullback the market experienced in early 2020.

John and Wade make a key distinction here…

Sometimes stocks climb above their 200-day moving averages because they are in incredibly strong bullish uptrends.

Other times, piercing the 200-day isn’t so much about strength, but rather, a recent market-price plunge dragged down the average. So, climbing about it isn’t all that challenging.

To illustrate this distinction, John and Wade provide the chart below of Southwest Airlines.

As you’ll see, the stock itself is trading at roughly the same level as it was in late 2018. However, the price is now above its 200-day moving average – even though it was below this average back in late 2018 – because the 2020-crash pulled down Southwest’s moving average.

Fig. 5 – Daily Chart of Southwest Airlines (LUV) — Chart Source: TradingView

Back to John and Wade:

Many of the stocks in the S&P 500 are in this same situation. That means they still have plenty of room to see their prices move higher.

***One more bullish tailwind for today’s market

Before wrapping up their analysis, John and Wade highlight another reason they believe this bull market has legs – low levels of short-selling.

Back to their update:

We’re seeing abnormally low levels of short-selling on Wall Street at the moment, which removes some of the bearish pressure that would normally be applied to the market as it becomes increasingly bullish.

Looking at the S&P 500 short interest as a share of market cap in Fig. 6, you can see that it is at its lowest level in decades.

Fig. 6 – Short Interest Compared to S&P 500 — Chart Source: Bloomberg

Short sellers are understandably a little gun-shy right now after watching GameStop (GME) shorts – along with a number of other short positions – get raked over the coals earlier this year.

This won’t last forever, but John and Wade think the muted short-pressure should continue into the summer. But if the market does correct, it will likely embolden short-sellers to come back in force…and with plenty of dry powder.

Wrapping up, the percentage of stocks trading above their 200-day moving average is at its highest point in more than a decade – but – this isn’t a contrarian, bearish indicator at the moment. There’s still strength in this market, even if it takes a pause to refresh itself.

Here’s John and Wade for their bottom line:

After the two-month rally that took the S&P 500 from just above 3,700 in early March to just below 4,200 in mid-April, the stock market is due for a break.

However, we expect this break will materialize in a consolidation range rather than an extreme bearish pullback.

This should leave plenty of opportunities for more bullish trades, so stay tuned.

Have a good evening,

Jeff Remsburg

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