: It’s time for stock market investors to get in caution mode, and here’s how to prepare for it

There are two reasons: Crowd sentiment is very bullish, and insiders are quite cautious. This is not a good combination.

Here’s why.

1. Excessive sentiment

For subscribers of my stock letter, Brush Up on Stocks (link in bio, below), I regularly track a dozen sentiment indicators. Right now, all of them are throwing off a bearish signal. This means they are measuring too much optimism. That sounds good, but it is actually bearish in the contrarian sense.

After all, the crowd is often wrong. And if nearly everyone is bullish, few people are left to convert to bullishness and buy your stocks. Another problem is that overconfident investors tend to be too easily surprised by bad news. They’re sure their new purchases can only go up. When stocks start to decline, they panic and sell. And the selling begets more selling. This makes the market vulnerable to a pullback.

Examples of excessive bullishness? Put buying (a bearish bet that stocks will decline) is minimal compared to call buying (a bullish bet). The Chicago Board Options Exchange equity put/call ratio is near the lowest level in 10 years. Next, consider my silver bullet sentiment indicator, the Investors Intelligence Bull/Bear Ratio. It just came in at 3.87. For perspective, anything above four is the warning path, by how I interpret this signal. Above five is a very clear signal that market weakness lies ahead. At least we are not there yet.

What does all this mean? Tobias Levkovich, Citi Research’s chief U.S. equity strategist, thinks the current level of bullish sentiment signals “a 100% probability of losing money in the coming 12 months” judging by historical patterns. “Indeed, we saw such levels back in early September, as well, right before a selloff in stocks,” he says. I was cautious ahead of the September pullback, too.

2. Cautious insiders

I’ve tracked insiders every day for 20 years. OK, that makes me a geek, but at least I have good feeling for the tone of insider buying and selling. I think this is better than quantitative measures that weigh selling against buying. Those are useful, but they have shortcomings. They include the activity of money managers who are not company insiders but still have to report activity because they have large positions. This muddies the water since the majority of money managers lag the market. Who cares what they do? I’m not that interested.

Other insider gauges try to “solve” this problem by eliminating all money managers. This is too blunt a tool, since it cuts out Warren Buffett and many money managers who actually are worth following. Indeed, as we see here, this approach missed the sell signal that I caught in late August ahead of the September sell off.

These two big-picture insider gauges also fail to capture which sectors insiders favor. That’s important. During March-June I was bullish on the markets and the economy because insiders heavily favored cyclical companies. Those outperform when the economy is improving. The insider preference for these names was a bullish economic signal for me, which many people missed. These two gauges also miss bullish insider patterns I look for, which amplify the insider signal.

Create your shopping list

I get why people are bullish. In my stock letter and in this column, I have been bullish since March (here, here and here, for example). I’m happy to see people join us, and push our stocks up. My logic has been that insiders were bullish in the right areas (cyclical, material and industrial stocks, and “reopening” plays); the virus wouldn’t last forever because vaccines would arrive; and the massive amount of stimulus put into the economy would create a very strong economy by the middle of next year. Now, many indicators confirm this view on the economy.

But the extreme sentiment and insider caution tell me it is a time to pull back from being bullish now. Avoid buying stocks on margin. Trim big winners and dubious trades. Create a short list of stocks you want to buy in any weakness, and have cash on hand to do so. Don’t sell out of long-term positions to try to time short-term moves. This is a tactical call.

In my stock letter, I recently suggested considering Morgan Stanley MS, +0.06% near $56, Avis Budget Group CAR, +1.59% near $37, Danaher DHR, -0.64% near $226 and B. Riley Financial RILY, -1.64% near $33. Otherwise, favor the right sectors.

“Any near-term volatility that helps unwind optimism should probably be seen as an opportunity to get well-positioned for the next leg of the cyclical bull market, adding exposure to small-caps, emerging markets and cyclical sectors,” says Baird investment strategist William Delwiche.

The one thing that bulls have going for them right now is that market breadth remains solid, by several measures Delwiche uses. Typically, any selloff foreshadowed by excessively bullish sentiment and insider cautiousness is preceded by a narrowing of market breadth. We don’t see that yet.

But the conditions are still in place that make the market vulnerable to a pullback. What might spark it? Not to be cute, but in a sense it doesn’t really matter. The key here is that overly confident buyers are too easily “surprised.” Whatever creates that surprise is less relevant.

But here are six likely candidates.

1. The virus mutates for the worse. You might not know this, but the Spanish flu still circulates today. So why isn’t it causing an ongoing crisis? It mutated into a weaker form. But viruses also mutate for the worse, and this could easily happen with Covid-19. Or else a new form could emerge that is not covered by the vaccines.

2. There is a surprise setback with one or more of the vaccines. There’s been such a rush to market, it’s possible safety issues could crop up.

3. A post-Thanksgiving surge in Covid-19 cases swamps hospitals so much, politicians force another broad lockdown. Anthony Fauci of the National Institute of Allergy and Infectious Diseases says it will take about two weeks to see how much Thanksgiving travel led to a wider spread of the virus. We’re not there yet.

4. The markets begin to worry about Georgia. Two Georgia Senate seats are still in the balance. If the Democrats take both in a Jan. 5 runoff, this would throw the entire elected Washington, D.C., power structure into the hands of one party, a status never welcomed by the markets. In one of the biggest disses of politicians by Wall Street ever (two groups are locked in a power-envy dynamic), investors prefer when power among the branches of government is split, so that politicians are less able to get anything done.

5. Inflation and interest rates rise. Inflation has been so dead for so long, no one expects it. So this would be a surprise. A spike in inflation is likely given the amount of stimulus pumped into the economy. Inflation will move into the 2% range, according to several market “predictors” of inflation such as copper prices, and the spread between the 10-year nominal Treasury bond yield and the comparable Treasury Inflation-Protected Securities (TIPS) yield. That would not be terrible. But a move in that direction would have investors wondering if inflation will get out of hand and spark Federal Reserve tightening.

6. Iran and Israel go to war. Iran may retaliate for the assassination of its nuclear scientist, Mohsen Fakhrizadeh. If Iran strikes Israeli territory or U.S. assets in the region, that would shake up the market, in part because of concerns about the disruption of oil tankers through the Strait of Hormuz.

Let’s hope none of this happens. But if any of these surprises, or some unknown unknown, play out, overly confident investors will be shocked into selling. That would spark more selling, and possibly a meaningful correction. Raise some cash and get your shopping list ready.

Michael Brush is a columnist for MarketWatch. At the time of publication, he owned RILY. Brush has suggested MS, CAR, DHR and RILY in his stock newsletter, Brush Up on Stocks. Follow him on Twitter @mbrushstocks.