Doomsayers Predicting Market Collapse: Why Stocks Could Rise

The stock market has been on a rollercoaster ride in recent months, with doomsayers predicting a catastrophic collapse. But history shows that extreme pessimism often precedes a market rebound. Let's dive into the data and see why stocks could be higher in the next few weeks.

First, let's look at the current level of investor pessimism. The AAII Investor Sentiment Survey shows that bearish attitudes have outpaced bullish ones by as much as 19%. This level of pessimism is the highest since late 2023, when some investors expected the economy to fall into recession. But what happened next? The S&P 500 rose 19% over the next three months. This historical performance underscores the benefit of objectively measuring market sentiment, as the Hulbert Stock Newsletter Sentiment Index (HSNSI) does.

The HSNSI recently fell far enough to be within the 10% of lowest daily readings since 2000, which in prior columns has been considered low enough to trigger contrarian interest. The table below contrasts the S&P 500's average return in the wake of these lowest decile readings and following the 10% of days in which the HSNSI was highest. In true contrarian fashion, the stock market performed significantly worse in the wake of extreme optimism than it did subsequent to periods like now, in which there was extreme pessimism.



But what's driving this pessimism? One key indicator is the unemployment rate, which has stabilized near 4% for the better part of the last year. This suggests a relatively strong labor market, which is generally positive for stock market performance. However, the doomsayers might be focusing on the slight increase in the unemployment rate from its cycle low of 3.4% set in April 2023, which could signal potential economic distress.

Another indicator is the Consumer Price Index (CPI) and Producer Price Index (PPI), which measure price changes in a range of goods and services. Rising inflation can hurt consumer spending, which makes up more than two-thirds of the GDP, and cause the Federal Reserve to raise interest rates to control price gains. Higher rates tend to cool economic activity and have squelched many stock rallies. For example, inflation eased slightly in February but has trended higher since last September, prompting the Federal Reserve to hold rates steady during the first quarter. This policy uncertainty and interest rate volatility have remained a feature of the bond market and will likely remain elevated until the policy outlook clears.

Additionally, the doomsayers might be focusing on the recent sell-off in the Magnificent 7 stocks, which has dragged the S&P 500 into correction territory from all-time highs set in February. This sharp sell-off could be seen as a sign of broader market weakness, despite structural factors and shifts in fiscal policy propelling European and Chinese markets ahead of the U.S. despite mounting trade tensions.

But let's not forget that the stock market is a forward-looking machine. It's always pricing in future expectations, not just current data. And if history is any guide, now could be a great time to buy. The last time the HSNSI was as low as it is now was in late October 2023. The S&P 500 over the next month gained 10%, and 19.1% over the next three months.



So, what should investors do? If you're a contrarian, now could be the time to buy. But remember, sentiment is not the only factor that moves the market. And insofar as contrarian analysis is correct, it applies only to the short term - up to three months or so, on average. So contrarian analysis tells us nothing about where the U.S. stock market will be later in 2025 and beyond. But don't be surprised if it's higher over the next few weeks.