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My Favorite Market Indicator Is Flashing "BUY"

 May 21, 2012 01:49 PM

(By David Sterman) 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%.

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