Wells Capital’s James Paulsen has been bullish — correctly — throughout much of the bull market that began in March 2009. But now, Paulsen says that a key sentiment indicator that has predicted many former declines is flashing a warning signal.
In a column for MarketWatch, Michael Brush talks about what he terms the “JP Factor”, a measure of market sentiment that Paulsen uses that involves a statistical tool called “R-squared”. “It basically determines what percentage of the market’s short-term moves can be explained by its medium-term trend line,” Brush explains. “Simply put, if markets have been in a steady uptrend for a while with small moves around an overall trend line — as they have been for the past several years — then ‘R-squared’ will be very high. It will be close to 100% on a scale of 0% to 100%. In other words, most of the daily moves are part of an overall market trend. This kind of environment makes investors very confident that more of the same lies just around the corner. And that’s a problem.”
Explains Paulsen: “If the market produces a steady rate of return like a CD payment, investors get pretty confident, calm and cavalier about what may happen tomorrow. It gets investors to stretch their normal behavior and go a little beyond their investment rules.”
Currently, the R-squared using Paulsen’s three-year timeframe is 97% — just the 14th time since 1900 it has been above 90%. “Eight of those [other 13] times, a bear market followed either right away or fairly soon,” Brush writes. Two other times, the stock market made a serious correction, though not right away, and two other times it was flat and volatile during the following two years. Only one time — in 2003 — has the signal failed.
“We have the most optimistic investors at a time when valuations are as high as they have been in this recovery and the Fed is resetting interest rates,” says Paulsen. “It could be sort of scary.”
That being said, Paulsen thinks we’re in for a 10% to 15% decline, not a full-fledged bear market. He thinks the market will be quite volatile this year, but that the bull market will eventually resume. He also thinks investors should decrease their allocations to US stocks and increase their Europe and Japan allocations. Emerging markets are a good way to get exposure to growth, he says.