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Clif Droke

Clif Droke

Clif Droke is the editor of the two times weekly Momentum Strategies Report newsletter, published since 1997, which covers U.S. equity markets and various stock…

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Why Investors are Paralyzed With Fear

The market is becoming more bullish by the week since last month's dominant short-term cycle bottom. Yet investors seem to be getting more paralyzed with fear with each passing week. Witness the latest AAII investor sentiment numbers: the bulls have declined to their lowest reading of the entire year at a mere 33%! Bears are a mere 26% But here's the kicker -- the neutrals have once again stolen the show with a 40% reading, one of the highest in years! Didn't I tell you a few weeks ago that the neutral reading on the investor sentiment figures would be the key number to follow in the next few years ahead? Back in the '80s and '90s you could safely ignore this number since it was usually insignificant, focusing instead on the bulls vs. bears. But now the neutrals have completely taken over the ball game, at least at certain times along the cycle.

I already discussed my interpretation of this tendency for the neutrals to explode in a past issue of the newsletter, but I'll repeat it. One reason why the neutrals have become a force to be reckoned with at certain times is because they are still feeling the burn from the grueling 2000-2002 bear market in stocks. They still have those losses fresh in their memories and are therefore loathe to get carried away with bullish sentiment like they were in past years. Another possible explanation for this explosion in the neutral camp at recurring intervals is that you have a whole new generation of traders and investors who are using various technical tools, and since they're all looking at the same data they tend to arrive at the same conclusions, hence "analysis into paralysis."

I firmly believe that the future will belong to those traders who are independent and resourceful enough to be able to read between the lines, knowing when to ignore certain "technical signals" and knowing when to adhere. In other words, a trader in today's market has got to be extremely versatile, always on his or her toes and ready to change tactics whenever the market stops responding to the old technical signals. Versatility is the name of the game!

Yet another reason why there exists this tendency for fear to build up to huge levels and manifest in the neutral sentiment readings is what I refer to as "conformity of information." That's a fancy way of saying that millions of traders/investors are all reading the same newsletters, newspapers, magazines, etc., and are all getting the same misleading info stuffed into their brains. How many widely circulated financial newsletters, for instance, were bearish heading into the early May cycle bottom (for that matter, are still bearish)? Quite a few! This just goes to show the danger of drinking at the same trough with everyone else, especially at critical market turning points.

Gone are the days of just being able to lay back and reap the windfall profits during a steadily rising bull market. This decade's bull market is likely to be unlike that of any previous generation (except possibly that of the 1930s). That's why it will take more work and tenacity to reap profits in the stock market of the next 3-5 years.

The good thing about this new breed of traders who are at times paralyzed with fear into inaction (we'll simply call them the "neutrals") is that they will make our job as fearless traders and investors slightly less difficult. You see, whenever there is a massive expansion in the neutral interest among the investor sentiment readings we'll know the market's next major move is likely to be to the upside. Apparently, the neutrals are today fulfilling the role that was filled by the bears in former years.

The last time there was such a great build-up in the neutral camp was a year ago as the 2003 market rally was just getting underway. This high neutral reading continued, as I recall, into the summer at which time more of the neutrals started filtering into the bullish camp. Of course by the time early 2004 came along there were too many bulls and not enough bears, hence the market declined into the late April/early May cycle bottom.

Since that time I've see the neutral reading balloon at important market bottoms, including most recently last month's dominant low. This is providing a growing body of evidence that the neutrals have, in fact, replaced the bears in terms of investor sentiment extremes.

Of course another clue that the late April/early May low was in fact a pivotal bottom was the huge number of bearish headlines in the financial press, which we discussed at length in Momentum Strategies Report (www.clifdroke.com). I actually constructed a collage of newspaper headlines from the Financial Times containing the words "fear," "pessimism," "concern," etc., and I ended up with something like 30-40 headlines over a three week period! I call it a "fear collage" as it personifies bearish investor sentiment. It's worth its weight in gold at major lows!

A significant increase in the reading of neutral investor sentiment means that a huge pile of money is on the sidelines just waiting to be piled back in as soon as the market looks inviting again. We know that the general public rarely sells short in great numbers, so this sideline money is typically earmarked for a rising market, not a selling market (as the bears would have us believe). Therefore from now on you'll know what it means when the neutrals start increasing and the fear becomes so thick you can cut it with a knife.

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