Indicators Flash Red, but Should Investors Stop?

The stock market has rallied briskly since early August, lifting key indexes to their highest levels in more than a year. But as Wall Street heads into September -- historically the weakest month of the year for stocks -- some analysts are troubled by long-reliable market indicators that are flashing red.

One gauge of investors’ attitude, the VIX index of options-market volatility, is pointing to extreme complacency. When it has sunk to these levels in the past it often has foreshadowed sharp declines in share prices.

Likewise, the heavily bullish tone in surveys of market newsletter editors and individual investors is a classic warning sign that stocks are near a peak. So are high levels of company insider stock sales while insider buying remains low.

To some analysts, these indicators suggest that the rally that has lifted the Standard & Poor’s 500 index 24% since March 11 is topping out. And yet the market has held up this summer in the face of soaring bond yields, and got a new head of steam in the last two weeks even though it’s well known to investors that September often brings a pullback in prices.

Some say all of this is encouraging, not scary.

“It’s acting like a bull market. It gets overbought and yet it doesn’t want to go down,” said Steve Todd, editor of Todd Market Forecast newsletter in Mission Viejo, who noted that stocks rose last week despite terrorist bombings in the Middle East and weak earnings from Hewlett-Packard Co.

“Imagine trying to push a beach ball underwater,” Todd said. “That’s what we have.” By contrast, “in a bear market it’s a bowling ball,” he said.

Some bullish analysts say market indicators such as the VIX may have lost their predictive power because too many people are counting on them to show the way.

Others say economic hopes now trump all: If you think the economy, and corporate earnings, will accelerate in 2004, selling stocks at this point would be a mistake, they say.

But bears say that ignoring the classic warning signs of a market top is simply foolhardy.

Here is what the numbers are showing and how market pros view them:

* The VIX index. The VIX, which tracks investors’ use of put and call option contracts on the blue-chip S&P; 100 stock index to gauge expectations of market moves, is considered dangerously low when it falls to about 20 or below. It closed at 20.27 Friday after hitting a three-year low of 19.23 on Tuesday.

Wall Street regards the VIX as a contrary indicator: When it is low it’s a sign that many investors already are in the market, aren’t hedging their bets and are optimistic stocks will keep rising, all of which implies there are few people left on the sidelines to fuel a new rally.

In August 2000, for instance, the VIX bottomed at 18.23 -- just as the average New York Stock Exchange stock reached its bull-market peak. Over the next four months the S&P; 500 sank 17%.

By contrast, the VIX reached extraordinary highs last fall, just as the bear market bottomed.

But some say the VIX may have lost its predictive punch, at least temporarily.

“In the past, the VIX has been very effective in showing complacency, and that has usually coincided with market tops,” said Joe Sunderman, director of trading at Schaeffer’s Investment Research in Cincinnati. “What’s different this time is how much attention it’s getting in the press.”

He likened the VIX to the so-called January effect for smaller stocks. In the 1980s Wall Street analysts widely touted the tendency of smaller stocks to outperform the rest of the market each January.

Since then, however, what might once have been January gains for smaller stocks often have occurred in October, November or December as investors have tried to get a jump on the phenomenon.

“Once people get burned by the VIX and say they’re going to toss it out of their playbook, then it might work again in the future,” Sunderman said.

Other analysts say the VIX has long been inconsistent.

Todd noted that VIX readings under 20 in early 1995 and 1998, for example, preceded strong market rallies. This year, the VIX fell to about 21 in mid-May, but “if you stayed away from the market because of that, you missed a 700-point gain in the Dow,” Todd said. The Dow Jones industrial average, which closed Friday at 9,348.87, was around 8,600 in mid-May.

“In a bull market the VIX will go down and stay awhile,” Todd said.

* Sentiment surveys. Bullishness has been high this summer in surveys by the American Assn. of Individual Investors and by Investors Intelligence, which polls market newsletter editors.

In AAII’s latest online survey last week, 63% of respondents were bullish on stocks, 18.5% were bearish and the rest were neutral. In last week’s Investors Intelligence poll, 55.1% of market newsletters called themselves bullish; 18.4% were bearish. The rest expected a modest short-term pullback in stocks at worst.

High levels of bullishness can be a concern because sentiment surveys, like the VIX, historically have been contrary indicators. If the vast majority of investors are bullish it often means there are too few people left to convince.

But recent bullish readings aren’t extreme, said Mark Hulbert, whose Annandale, Va.-based Hulbert Financial Digest tracks newsletter trends.

He noted that bullishness in AAII’s weekly poll is down from 71.4% on June 2. In the Investors Intelligence survey, bullishness briefly topped 60% in 1992, 1999 and 2001. “In the short term, there’s not so much bullishness [that] you would send a warning signal that the rally that began in March must come to an end,” Hulbert said.

Nonetheless, “from a long-term point of view, one has to be cautious about whether a bull market has started in earnest,” he said, noting that in the last three years, pessimism hasn’t been sustained for extended periods, such as three months.

A deep, prolonged bearishness typically marks major market bottoms, Hulbert said.

* Insider selling. Corporate executives, directors and large individual shareholders have been heavy net sellers in August for the fourth straight month, data from New York-based Thomson Financial show.

In forms filed with the Securities and Exchange Commission from Aug. 1 through Wednesday, insiders reported buying $58.6 million of their own stock on the open market, up from $34 million at the same point in July. But they sold $2.1 billion in shares, more than double the $828 million in the month-earlier period.

August could be the fourth straight month in which the ratio of shares sold to bought, in dollar terms, is above historically “very bearish” territory of 20 to 1, said Thomson analyst Lon Gerber. Through Wednesday, the ratio was 36 to 1.

Insiders, as the theory goes, are in the best position to know whether their firms’ business prospects are getting better or worse, and whether their stocks are overvalued or undervalued.

But Wall Street’s optimists say that even if these classic indicators are correctly foreshadowing a market pullback, the question is how substantial, and lengthy, the decline might be.

If key indexes are headed for a typical 10% to 15% “correction” at worst in coming weeks, the issue is whether it’s worth it for investors to sell out if they believe that the economy, and share prices, are more likely to advance than decline in 2004.