Thinking Process: Current Pessimism Signals End Of Correction

Greek default concerns, sharp Euro sell-off, slowing global economy including US and China, a new recession in Japan, commodities mini-crash, "sell in May and go away" and US default concerns, plus many other problems seem to be weighing heavily on investors.

After looking at the current survey readings from the American Association of Individual Investors (AAII), I've noticed that there were hardly any bulls. The readings stand at 26.7% Bulls, 41.3% Bears and 32.0% Neutral. Since March 2009, when the bull market in equities started, we have only seen bullish readings this low or lower, four other times. All four presented buying opportunities. The last time bearish sentiment outnumbered bullish sentiment by this amount or more, was back in June and August 2010, when S&P 500 stood between 1010 and 1100. We all know what followed thereafter.

What is very strange however is that usually these type of sentiment readings occur as the market sell offs, just like in during May - August of 2010. This time around, the market has just moved sideways since early April and yet bullish sentiment is approaching levels which usually present a good buying opportunity, if history is any guide.

History shows that as bullish sentiment decreases, returns tend to increase, while overly optimistic and extremely bullish readings, on the other hand, do not necessarily forecast losses. The chart above shows that a bullish reading of 28% or lower tends to create returns in excess of 3% over the next three months, which in this case could mean that the S&P 500 could be destined towards new bull market highs, above 1,380.

However, there are those, known as smart money, which tend to disagree with very strong S&P 500 performance from here on. These including Marc Faber, Jeremy Grantham, Jim Rogers, Robert Prechter etc. These market veterans think that the stock market is overbought from the longer term cyclical perspective, so therefore my view is that the current short term pessimism might be an opportunity to look at other asset classes, such as shorting US Government Bonds on the long side of the curve, which have benefited with a 10% rally as February 2011.

As we can see from the chart above, the best time to buy government bonds from the contrary point of view, is when the economy is performing well, because we know that the next cycle will be down. Current pessimism, therefore signals that the economy might actually surprise to the upside during European summer months. Citigroup's Economic Surprise Index, as shown above, is one of the best ways to track economies momentum. Government bonds tend to rally as economic momentum peaks and than thereafter surprises to the downside. The opposite is also true, because when there is too much pessimism around and economies weak momentum becomes quite recognised, than one should sell government bonds, and enter the risk trade again. So therefore, shorting US Government Bonds, which have been in a 30 year secular bull market, might just be a smarter move than buying stocks right here, after a 100% gain since March 2009.