Pessimism remains the dominant sentiment

ANALYSIS:Pessimism is reaching levels often associated with tradeable market bottoms

THE YALE School of Management's Crash Confidence Index, which asks individual and institutional investors for their confidence that there will not be a market crash in the next six months, has fallen to its lowest level in the survey's history. Previously, the lowest reading was recorded in November 2002, just after markets had bottomed following the worst bear market in decades. A separate confidence survey from the same institution shows a growing divergence between institutional and individual investors, with the latter increasingly pessimistic while confidence in the former group is ticking higher.

The Yale results tally with the 10-year high in bearish sentiment recorded by Investors Intelligence, who measure bullish and bearish sentiment among newsletter writers. Extreme signals in either direction are regarded as a contrarian signal by many analysts. Similarly, the latest poll by the American Association of Individual Investors (AAII) reveals a marked increase in bearishness, with more than twice as many retail investors categorising themselves as bearish (55 per cent bears, 22 per cent bulls).

The AAII survey is a famous indicator of "dumb money", with extreme readings typically recorded after rather than before a significant market move. It's uncommon to see bears exceed 50 per cent. In fact, during the 2000-2002 bear market, the only reading above 50 per cent was recorded at the very tail end of the bear market, with hopeful investors continuing to "buy the dips" before finally capitulating as the selling grew increasingly intense.

Of late, retail investors have been consistently wrong. The latest reading is just below the extreme readings of January and March, just prior to strong bear market rallies. By May, more than twice as many investors were putting themselves in the bullish camp, which coincided with the markets topping after a strong double-digit bear market rally. Indeed, the May bullishness marked the most optimistic reading since the market top last October.

That many investors are giving up is unsurprising given the awfulness of market conditions this year. Global equity markets have lost almost $13 trillion since last October. The MSCI World index has fallen by 15 per cent in 2008, its worst start to a year since 1970. Even Berkshire Hathaway, billionaire investor Warren Buffett's investment vehicle, has lost 20 per cent since December, underperforming the SP 500 in the process. That was its worst first-half performance since 1990. Berkshire has recorded gains in 17 of the last 20 years but unless there's a dramatic turnaround in market fortunes, 2008 is going to be different.

Still, the latest sentiment surveys should provide contrarians with some crumbs of comfort, as might the fact that short sales have hit record levels of late, rising by 55 per cent since the market peaked last October. Short sellers borrow shares with the intention of buying them back - "buying to cover" - at a lower price. A report by JP Morgan last week noted that a record 36 per cent of SP 500 companies have at least 5 per cent of their shares sold short, with 18 per cent having more than 10 per cent of their shares shorted. With such "extreme levels" of short interest, any market positive "could trigger a substantial short-covering rally," the report said.

Bearish observers might counter that short sales have been increasing at a record pace for months now. Despite this, market rallies have been distinctly thin on the ground, with even "good" news unable to trigger any major bout of short-covering. News that the US government was effectively bailing out beleaguered mortgage giants Fannie Mae and Freddie Mac led to a strong opening for US markets yesterday. Instead of triggering the much-awaited short-covering, however, markets gave up their gains and then some within the first hour of trading. Fannie and Freddie, after earlier rallying 32 per cent and 26 per cent respectively, dipped into the red in afternoon trading.

Indeed, to sceptics, the rapid decline in fortunes at Fannie and Freddie is proof that the ongoing credit crisis is only beginning to be felt. Goldman Sachs analyst Daniel Zimmerman said both shares might fall by another 35 per cent, a viewpoint shared by Jim Rogers, co-founder of the legendary Quantum fund with George Soros. Rogers yesterday described the bailout as an "unmitigated disaster".