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Optimism Signals Stock Declines May Continue: Technical Analysis

The retreat in the Standard & Poor’s 500 Index may not be over, as a gauge of bullishness reached levels that coincided with the market’s peak in 2007 and preceded the biggest pullback in both of the last two years.

The Consensus Bullish Sentiment index on stocks, based on a weekly survey of brokerage strategists and newsletter writers, exceeded 75 percent for seven weeks through April 3, the longest streak since Kansas City, Missouri-based Consensus Inc. began compiling the data in 1983. The index fell to 69 percent this week as the S&P 500 had the worst five-day drop since November amid concern the recovery in the American labor market is slowing and Europe’s debt crisis is worsening.

Optimism has grown as the S&P 500 finished its best first-quarter rally since 1998, bolstered by better-than-expected economic data and corporate earnings. Increasing bullishness is considered a contrarian indicator by some analysts who follow price charts to make market predictions, because investors who have bought shares now have less money to purchase stocks.

“We’re concerned at what we view as very complacent bullish sentiment, almost frothy, and it needs to be unwound,” John Kattar, chief investment officer at Eastern Investment Advisors in Boston, which manages $1.7 billion, said in a telephone interview. “We should see some fear creeping back into the market, but we’re a long way from that happening yet.”

Five-Day Decline

The S&P 500 yesterday snapped a five-day decline after Alcoa Inc. reported an unexpected first-quarter profit. The benchmark measure reached its highest level since May 2008 on April 2 and fell 4.3 percent over the following five days. Katter said he expects to see a pullback of 5 percent to 10 percent.

Consensus says a reading above 75 percent in its sentiment index suggests the market may be poised to fall, while a reading below 25 percent signals a potential rebound. The measure has averaged 43 percent since its inception.

Since 2007, there were five other occasions when brokerage strategists and newsletter writers were so optimistic. The Consensus index exceeded 75 percent for four straight weeks in May 2007 and again for the week of Oct. 16 that year. The S&P 500 peaked at an all-time high of 1,565.15 on Oct. 9, 2007.

Sentiment readings reached 76 percent in April and May of 2010. That year, the S&P 500 hit a 19-month high on April 23 before slumping 16 percent to the year’s low.

In 2011, the sentiment index exceeded 75 percent only in March. The equity gauge reached its peak of the year the next month and tumbled 19 percent through October, the worst decline since the bull market began in 2009.

The S&P 500 is down 2.8 percent this month after rallying 12 percent in the first quarter. The retreat may push the benchmark measure toward 1,340, a level close to the index’s intraday low on March 6, according to Katie Stockton, chief market technician at Greenwich, Connecticut-based MKM Partners.

“The pullback has not run its course yet, but it has been constructive so far,” Stockton wrote in an e-mail.

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