Stock Market Caution: Investors' Optimism May Spell Trouble Ahead

If you're not already a subscriber, you can sign up for CNN Business' Before the Bell newsletter to get access to exclusive content. Simply click the link provided. Additionally, you have the option to listen to an audio version of the newsletter using the same link.

In the world of investing, when the market is bullish and on the rise, the bears are lurking and prepared to take advantage of any downturn.

The S&P 500 hit its 17th record-high close of 2024 on Tuesday, but has pulled back slightly due to renewed inflation concerns. The Dow Jones Industrial Average has also been setting multiple record highs this year, while the Nasdaq Composite achieved a record high in February for the first time since 2021. Gold and bitcoin have also experienced surges to all-time highs.

It's no surprise that there are several flashing indicators indicating that investors are optimistic about the market.

• The CNN Fear & Greed Index indicates market sentiment, including the VIX, a measure of expected stock volatility, is currently showing "greed."

• According to the AAII Investor Sentiment Survey, around 46% of investors believe the market will head in a "bullish" direction in the next six months. This is higher than the historical average of 37.5%.

According to the Charles Schwab Trader Sentiment Survey, around 53% of participants showed a positive outlook for US stocks in the latest survey. This is a significant increase from the 32% reported in the fourth quarter of 2023 and marks the highest level of optimism since the survey began in 2021.

However, high levels of market optimism may actually signal potential trouble ahead. Market sentiment is often viewed as a contrarian indicator, meaning that when the majority of investors are optimistic, professional money managers may interpret it as a warning sign that stocks could soon decline, and vice versa.

Investors and market sentiment can be influenced by emotions rather than rational thinking. This can lead to decisions driven by fear of missing out or fear of significant losses, causing investors to buy high and sell low. Therefore, positive vibes on Wall Street may not always indicate genuine support for a sustained market rally.

The Investors Intelligence bull-bear ratio is a key indicator that compares the level of optimistic advisers to pessimistic ones. According to Yardeni Research, the ratio dropped to a low of 0.57 during the week of October 11, 2022, marking the lowest point since the financial crisis. Interestingly, the previous bear market hit its lowest point the very next day.

In early November (2022), our researchers became optimistic as they felt that people were overly negative, and the anticipated recession was not materializing as expected.

Looking ahead, the bull-bear ratio increased last week to 4.20, marking the highest level since December 2017, according to data from Yardeni Research.

Stocks have continued to rise this year for reasons beyond just positive sentiment.

Recent data reveals that the economy is still strong, even though interest rates have been at a 23-year high since July. In February, the economy saw a significant increase of 275,000 jobs, as reported by the Bureau of Labor Statistics. Additionally, the Personal Consumption Expenditures price index, which is the Federal Reserve's preferred measure of inflation, showed a decrease to its lowest level in over two years in January.

The Fed is expected to lower rates this year, with the first cut likely in June or July, as indicated by the CME FedWatch Tool. This decision is supported by the data that has been gathered.

The economy's strength was further highlighted during the recent earnings season. According to FactSet data, fourth-quarter earnings for S&P 500 companies are projected to increase by 4.1% compared to the previous year.

Another inflation gauge came in hot for February

Rising energy prices helped to fuel yet another hot inflation reading for February, reports my colleague Alicia Wallace.

A new report released on Thursday shows that a key measure of wholesale inflation in the US has increased at a rapid pace. The spike in prices is mainly due to a seasonal rise in energy costs, while other categories that are less prone to fluctuations are indicating a gradual decrease. Despite this, the latest Producer Price Index highlights the ongoing challenge of controlling inflation.

According to data from the Bureau of Labor Statistics, the Producer Price Index, which tracks the average price changes for producers and manufacturers, surged by 1.6% in the 12 months leading up to February. This is a significant jump from the 1% increase seen in January. Economists had predicted a smaller annual increase of 1.1% for February.

On a monthly basis, PPI increased by 0.6%, which was double the 0.3% rise expected by economists. Energy prices jumped by 4.4% from January, marking the largest monthly increase since August 2023.

PPI measures changes in average prices before they impact consumers, offering a potential indicator of the prices consumers will eventually face.

The February PPI report brought a mix of results, according to Gus Faucher, chief economist for PNC Financial Services. In a note released on Thursday, he mentioned that inflationary pressures are still present, but as supply and demand levels return to pre-pandemic levels, inflation is gradually decreasing.

Retail sales rebounded in February

Spending at US retailers rebounded last month as Americans shelled out more for gasoline, reports my colleague Bryan Mena.

Retail sales at stores, online, and in restaurants increased by 0.6% in February compared to the previous month, following a revised 1.1% decrease in January, according to the Commerce Department's report on Thursday. This growth was slightly lower than what economists had predicted. The figures are adjusted for seasonal changes but do not account for inflation.

The decline in January was largely due to the cold weather, which kept consumers indoors. Despite this, the overall US economy remains strong, with businesses still hiring and workers seeing significant wage increases. Retail spending has risen in seven of the last ten months leading up to February.

Sales saw growth in various categories last month. Home improvement stores experienced the biggest increase at 2.2%. Car sales went up by 1.8%, while purchases of electronics and appliances increased by 1.5%. Additionally, sales at restaurants rose by 0.4%.

In February, gas station sales also saw a rise of 0.9% compared to January.

Meanwhile, furniture sales dropped last month, falling 1.1% from January. Sales at grocery stores, clothing retailers and online were also down in February.

Read more here.

Editor's P/S:

The article highlights a paradoxical situation in the stock market, where bullish sentiment is reaching extreme levels while indicators suggest potential trouble ahead. The euphoria and optimism among investors, as indicated by the CNN Fear & Greed Index, AAII Investor Sentiment Survey, and Charles Schwab Trader Sentiment Survey, raise concerns about a contrarian effect. Historical data shows that high levels of market optimism often precede market declines.

Despite the bullish sentiment, the article presents a balanced view by acknowledging the underlying strength of the economy, including strong job growth, low inflation, and rising earnings. However, the recent PPI report indicating an increase in wholesale inflation and the rebound in retail sales due to higher gasoline prices add to the complexity of the market outlook. Investors should exercise caution and consider the potential risks associated with over-optimism while also acknowledging the positive fundamentals supporting the market.