This Investor Sentiment Indicator Has an Incredibly Successful Track Record of Forecasting Stock Market Bottoms

What a difference a year makes! In 2021, the worst decline investors faced was a small 5% volatility in the benchmark. S&P 500 (^GSPC 0.92%). This year, the S&P 500 is entrenched in a bear market, down 28% from its peak. What’s more, it posted the worst first-half return since Richard Nixon was president.

Other well-followed indices have also fared poorly. Out of time Dow Jones Industrial Average (^DJI 0.10%) briefly entered a bear market with a 22% peak decline while driven by technology Nasdaq Composite (^IXIC 1.88%) 38% less than a year ago.

A twenty-dollar paper airplane, crumpled and crumpled in a financial newspaper, with stock quotes visible.

Image source: Getty Images.

The $64,000 question: Where will the stock market bottom?

The uncertainty and speed of downward movements during bear markets can play on investors’ emotions and force them to make decisions. That’s what new investors and incumbents are wondering when and where the stock market will bottom out.

To be perfectly honest, if there was a foolproof indicator that accurately predicted when bear markets would occur, how long the decline would last, and where the bottom would be, every investor on the planet would be using it by now. Because the catalysts are different for each stock market decline, and the emotions/reactions of investors are never exactly the same to those declines, there is no precise way to know in advance when or where the stock market will bottom.

But that doesn’t mean there aren’t indicators that are incredibly successful at steering the investment community in the right direction.

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Over the past few months, I’ve looked at a number of metrics that have a long history of (relatively) accurately predicting how much the decline will be or when the stock market will bottom. . This includes everything from valuation-based indicators to more traditional measures such as outstanding margin debt. I also recently offered a correlation between Federal Reserve monetary policy and stock market bottoms.

But there is another way to predict stock market bottoms: sentiment-based indicators.

A highly anxious person is watching a stock chart displayed on a computer monitor.

Image source: Getty Images.

This measure of investor sentiment has historically been an excellent buy signal

While there are plenty of gauges and gauges designed to gauge how greedy or fearful investors are feeling at any given moment, a technical indicator could be far more useful in identifying key buying opportunities. Specifically, I’m talking about the percentage of S&P 500 stocks above their respective 200-day moving averages.

Moving averages are a basic product of technical analysis, the average of a company’s stock price over a certain period of time. The assumption is that moving averages will provide some level of support or resistance, depending on which side of the moving average line a stock finds itself on.

But average cellphones aren’t particularly useful by themselves. They don’t tell us anything about what makes a company tick or what are the catalysts for its future. Moving averages, however, can provide an accurate look at investor sentiment.

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Throughout history, investors have become accustomed to bullish valuations in bull markets and become overly pessimistic in bear markets. By looking at the percentage of S&P 500 stocks above their 200-day moving average and comparing that figure to historical figures, we can identify when investors are bullish or bearish.

Currently, 37.6% of the 500 companies that make up the S&P 500 are trading above their 200-day moving average. That is not a particularly representative figure one way or the other. However, since the beginning of 2002, there have been a dozen instances where the percentage of S&P 500 stocks above their 200-day moving average has fallen below 18%. Each of these cases represented a unique buying opportunity.

But there’s a caveat to this investor sentiment indicator: it’s not for short-term traders. Just because investor sentiment is poor doesn’t mean it can’t get worse.

In the depths of the Great Recession of 2009, the percentage of S&P 500 stocks above their 200-day moving average didn’t bottom until it hit just 1%! In other words, this is not an indicator that will tell you exactly when a bear market bottom will occur. Rather, it offers a successful history of accurately predicting the approximate bottom of the most followed stock market index, alerting investors to overly negative investor sentiment.

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History is in favor of long-term investors

But this isn’t the only metric that can put a little pep in an investor’s step. Historically speaking, every major decline in the stock market has represented a sure buying opportunity for long-term investors.

According to the sell-side advisory firm Yardeni Research, the S&P 500 has fallen at least 10% 39 times in the past 72 years. In short, stock market corrections, and even bear markets, are probably more common than you think. However, in each of these cases (except the current bear market), a bull market rally recovered all that was lost. Given time, “this too shall pass” will be the reason, once again.

To take things a step further, the data showed that the S&P 500 has never let investors down if they are willing to buy and hold a tracking index for 20 years. Based on data published by market analytics firm Crestmont Research, the S&P 500’s 20-year total return, including dividends paid, has never been negative since 1900. In plain English, it means that when you bought the S&P 500 tracking index from the early 1900s, you got richer as long as you held it for 20 years. This means that any time now is a good time for patient investors to put their money to work on Wall Street.

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