September's stock market rally, the best September since 1939, was impressive not only because of its magnitude, but also because of its influence on investor sentiment. The American Association of Individual Investors (AAII) sentiment poll surged from 20.7% bulls on August 26, 2010 to 50.9% bulls as of September 16, 2010. While the three week increase may not seem significant, an increase this big has only occurred 7 other times during the 1204 weeks since AAII started accumulating this data in 1987 (Figure 1).

The change in optimism can be attributed to a newly held view, recently conveyed on CNBC by a well-known investor, that investing in stocks is a win-win proposition because either the economy will grow or the Federal Reserve will print enough money to make the stock market rise. Since investing is never risk-free, we question any thesis suggesting that one cannot lose.

Figure 1. An Extreme Rise in Bullishness: The Largest 3 Week Gains in Bullish Sentiment Since 1987

Source: American Association of Individual Investors, Continental Capital Advisors

Rapid increases in bullish sentiment usually trigger a contrarian sell signal for equity markets. The figure above shows that in 5 of the 7 times when sentiment leaped over 30% in three weeks, equity returns were poor 3 and 6 months later. While the indicator does not always give a contrarian signal, it has paid to be cautious in the past. Note that the greatest increase in bullish sentiment took place just before the 1987 stock market crash, while 4 others occurred just prior to the peak of the NASDAQ bubble or during the bear market rallies that followed it. Additionally, one-month returns following a peak in bullish sentiment have only recorded gains above 4% on one occasion. Since the most recent sentiment peak on September 16, stocks have already moved 2% higher; this suggests that further upside could be limited.

The rationale for the current surge in sentiment was conveyed by a well-known hedge fund manager on CNBC last week. He said:

Either the economy is going to get better by itself in the next three months and what assets are going to do well? You can guess the assets. Stocks are going to do well. Bonds won't do so well. Gold won't do as well. Or the economy is the not going to pick up in the next three months and the fed is going to come in with QE. Then what's going to do well? Everything, in the near term. Everything.

September's rapid increase in bullish sentiment is in sync with an outlook that stocks can only rise - after all, why else would investors be so bullish on equities? However, there have been many times when investors thought prices could only rise, including at least three times within the past decade: with technology shares in 1998-2000, housing in 2007, and oil in 2008. In all three cases prices not only stopped rising, but also fell dramatically.

Inherent in the win-win thesis is an assumption that the Federal Reserve can control the economy and markets. Of course, if that were true there would never be recessions or bear markets in the first place. Throughout both the 2000-2003 and 2007-2009 economic contractions investors chose not to 'fight the Fed' and bought stocks in anticipation of the perceived benefits of interest rate cuts. During those periods, investors who placed their faith in the Federal Reserve, as many are doing today, were misled into buying stocks too early or holding them too long.

Trying economic times combined with a surge in positive investor sentiment and the faulty view that the Federal Reserve will not allow stocks to fall have created substantial risk for equity markets. Now that investors believe that they cannot lose, they probably will.