Regular investors have been 'buying the dip' aggressively. Remember: Be fearful when others are greedy.
Individual investors' eagerness to "buy the dip" suggests that the stock market is close to a significant top.
I'm referring to the behavior of retail investors in the wake of the stock market's early-April plunge, when the S&P 500 SPX shed more than 12% in just four trading sessions. "An army of amateur investors stepped up to buy the dip with both hands," my MarketWatch colleague Joseph Adinolfi recently reported. "April was one of the most aggressive months of buying by the retail cohort in recent memory."
This bodes ill for the stock market because widespread "buying the dip" behavior among retail investors is a hallmark of market tops, just as reluctance to buy the dip typically occurs near market bottoms.
Consider a sentiment index created by Yale University finance professor Robert Shiller, known as the "Buy on Dips Confidence Index." This monthly survey is based on the answers that retail investors give to the following question:
"If the Dow dropped 3% tomorrow, I would guess that the day after tomorrow the Dow would: [Circle 1, 2, 3, or 4]
-- Increase____ Give percent: -%
-- Decrease____ Give percent: -%
-- Stay the same
-- No opinion
Shiller calculates each month's index level by dividing the number of respondents who choose the first option by those who choose options one, two or three.
The table below summarizes the index's record since mid-2001, when the survey began. The S&P 500's prospects after low index readings are significantly better than after high index readings. The differences reported in the table are significant at the 95% confidence level that statisticians often use when assessing whether a pattern is genuine.
Because Shiller reports this index with a several-month lag, there's no way of knowing its current reading. But based on numerous reports such as the one mentioned above, I'm confident it is at or near the upper end of its historical range. As Adinolfi wrote: "April was one of the most aggressive months of buying by the retail cohort in recent memory. Since April 8, a team of analysts at JPMorgan estimated that individual investors had bought $50 billion in stocks. At times, they accounted for roughly a third of daily trading volume."
According to contrarian analysts, a market bottom will be close when retail investors engage in just the opposite behavior than "buying the dip." To put that another way, a bottom will be imminent when investors eagerly use the occasion of every rise in the market to reduce their stock exposure.
Such fearful investor behavior isn't apparent nowadays. It becomes even more remote with each successive dip in which investors are rewarded for buying. Their successes lead them to become even more stubbornly committed to buying the dip.
That stubbornness means it will take an ever more severe downturn to rebuild the sentiment preconditions for a major new leg upward in the market. It won't be pretty.
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