My Favorite Market Indicator Is Flashing “BUY”

Stocks are on a major losing streak. The S&P 500 has fallen for five straight sessions and has risen on only three occasions this month. The lift from a solid earnings season has passed, scary headlines from Europe are splashed across the front pages and investors are frightened.

Just how frightened are they? They’re as bearish as they were back in October 2011, which not coincidentally, also marks the time when the market kicked off a furious six month rally. In fact, right now, there are two bearish investors for every bullish one. Less than 25% of investors feel confident about the market right now. That news comes from the weekly survey  conducted by the American Association of Individual Investors (AAII).

This should be your cue to start buying.  Sure, stocks can fall further from here, but this weekly survey has a remarkably accurate ability to forecast the direction of the stock market. Indeed, when bulls made up more than 40% of this weekly survey, as was the case in March 2012, that’s historically been a good time to take profits. Yet a move below 25% is a stark, bold buy signal. Don’t take my word for it. Look at the data…

I went back through 25 years of data and found a remarkable correlation. On many occasions, extreme levels of pessimism can represent a market bottom. And the snapback can be profound, if you’ve got a six, 12 or 24-month time horizon.

This gauge didn’t work when bearishness peaked in 2008 — stocks fell a lot lower and were only flat three years later. Yet every time, investors have scored at least a 37% three-year return. The average three-year return on all 10 dates (up through March 5, 2009) noted above: 40%.

The average two-year gain is almost as impressive at 26%. Even just a year later, the average return is a solid 11%. Add it up, and you would average double-digit gains for three straight years by following this signal.

#-ad_banner-#Why it works
There’s really not a lot of mystery to this. When stocks are rallying, much of the idle cash that had been on the sidelines has been put into play. No amount of further good news can really help if investors are already heavily-invested. Conversely, at moments of peak bearishness, idle cash rises, and it can take only the smallest shifts in market sentiment to lead that sidelined cash back into the market.

That’s the logic that underpins some of the world’s top investors. Recall the lousy backdrop for stocks in the summer of 2011. The market began a freefall on July 22, and on August 8, had its worst day yet, with the S&P 500 falling more than 5%. We found out a few weeks later that August 8 was the single most aggressive buying day that Warren Buffett has ever undertaken. He took advantage of the fear to load up on loads of stocks.

Well, two months later, in early October, the S&P 500 was actually lower than the day of his shopping spree. Was his timing off? No way. He’d be the first to tell you that he can’t name the date of a market bottom. Instead, he’d tell you that he knows bargains when he sees them. Roughly seven months later, the S&P 500 was 20% higher.

Buy into weakness
Since we have no idea how the market will trade in coming sessions, it’s unwise to pour all of your funds into the market at once. Instead, look at this bearish investor sentiment survey as a starting point. Every day of fresh market weakness should be an opportunity to get a little more exposure to stocks. Nibble here and there on stocks that increasingly represent solid value plays. They may still fall a bit lower in the near-term, but the long-term opportunity should be self-evident.

My favorite time to buy: When stocks “capitulate.” That 5% slump in the S&P 500 back on Aug. 8, 2011? That was capitulation because just about every investor simply threw in the towel. We may or may not get such a radical sell-off this time around, but if we do, ignore your fears and boldly march into stocks.

Everyone’s got their own wish list and I’d like to share mine. These are a list of blue chip stocks, though even deeper values lie among many mid-, small- and micro-cap stocks right now. Every one of these stocks has traded lower in the recent market slump, and in each instance, represents clear value, whether in terms of price-to-book value, price-to-cash-flow or price-to-earnings. These stocks could still fall lower, but I’ve got a strong feeling that many of them will be well higher in a few years:

Ford Motor (NYSE: F)
Freeport McMoran (NYSE: FCX)

Alcoa (NYSE: AA)
• Citigroup (NYSE: C)
Charles Schwab (Nasdaq: SCHW)
• ArcelorMittal (NYSE: MT)
Applied Materials (Nasdaq: AMAT)
Oracle (Nasdaq: ORCL)

Risks to Consider: An utter meltdown of the global financial system, as we saw in 2008 and early in 2009 is always the elephant in the room. It’s highly unlikely we’ll see stocks fall so deeply this time around, but a day of “capitulation” may still give a shock to the market in coming weeks or months.

Action to Take –> This is a great time to stress-test all of the stocks you are looking at. Check out companies’ historical profit levels, pour over the balance sheets, and zoom in on the stocks that simply appear mispriced in relation to their track record and financial strength. If history is any guide, then the current climate of investor fear has led to an overreaction in some of these stocks, and you’ll profit handsomely when things get righted.