Market hype triggers 'new major warning' sign for stocks

Key Points
  • Bullishness in the most recent Investors Intelligence survey hit 60.2 percent, compared with 16.5 percent for bears.
  • High levels of optimism often serve as early indicators of market weakness ahead, as they did in February.
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With a fresh round of record-breaking highs in the stock market has come a surge in investor optimism, and that eventually could create problems.

Bullishness in the most recent Investors Intelligence survey hit 60.2 percent, the highest level since late February. The survey comes from editors of market newsletters and thus provides a snapshot of what professional investors are thinking.

Elevated levels of optimism often coincide with market dips. The last time the II survey hit this level, the proceeded to fall nearly 3 percent.

John Gray, editor at II, cautions that the big spread between bulls and bears, who are at just 16.5 percent, is an indicator of potential danger ahead.

"The latest sentiment is not encouraging for the rest of the year as markets rarely fulfill expectations," Gray wrote. "This is a new major warning calling for defensive measures to protect profits, renewing the same signal from earlier this year."

While there's been plenty of talk in the market about elevated levels that could trigger a correction — or a 10 percent drop — II respondents don't see it happening. Expectations for a correction dipped to 23.3 percent of respondents.

Michael Nagle | Bloomberg | Getty Images

By comparison, the correction reading was at a comparatively lofty 34 percent prior to the November presidential election — just before the market surged on hopes that President Donald Trump would usher in a new pro-business era in Washington.

Since hitting the most recent bottom earlier in July, the market has been on what is just the latest leg higher. Defying expectations that stocks could see limited gains this year, the S&P 500 has climbed 10.6 percent on strength in tech, materials, health care and discretionary stocks.

However, there is some caution out there.

Among the sampling of newsletter sentiment that II cited was a warning from Bert Dohmen's Wellington Letter, which said the Fed could thwart the rally.

"As long as Fed officials talk about hiking rates, it will enhance concerns about the Fed
producing a recession," Dohmen wrote. "We interpret each rate hike as another nail in the coffin for an economic recovery."

Ten of the last 13 Fed rate-hiking cycles ended with recession. Dohmen said that could be the case again, though he did not advocate that investors panic.

"We are seeing warning signs, but not enough to run for the hills just yet. We have said for a number of months that the final phase in the bull market should be a noticeable spurt to the upside, forcing all skeptics into the market," he wrote. "We haven't seen that yet."

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