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Why Popular Sentiment Could Be Right, a Correction Could Be Near

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One hedge fund manager is rather convincing, predicting a near term pullback at the end of this week that could bring declines of 10% or more.

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Editor's Note: Michael Brush is the editor of the stock newsletter Brush Up on Stocks and a weekly market columnist for MSN Money.

So many stock market pundits have noticed the bullish turn in popular sentiment and forecast a pullback as a result, it's tempting to think a correction won't happen near term -- just because too many of the "experts" expect it.

After all, it's hard to read a market website or blog now without seeing some stock commentator predicting a reversal because of the bullish tone in the Investors Intelligence Bull/Bear Ratio, or the American Association of Individual Investors Bull Ratio.

But if you're a natural market contrarian like me, it's important to avoid falling into the trap of thinking consensus (in this case, among commentators) is always wrong. Sometimes the market pundits are right, even when so many of them are all predicting the same thing. Right now, a couple of behind-the-scenes sentiment indicators are suggesting that's the case.

The head of research at a major hedge fund, who had a great 2010, up more than 50%, just moved a lot of his portfolio to cash -- ahead of what he believes will be a significant pullback starting January 7.

Here's the rationale.

First, he tracks Medicare tax payments as a predictor of what upcoming employment reports will bring. Here, the news is not good. Because while many investors are focused on the fact that overall tax receipts are up 7% year over year for 2010, which seems bullish, Medicare receipts have been in decline of late. This suggests the employment report due out this Friday could show unexpected weakness.

On top of this, two other sentiment measures now show the kind of excessive bullishness they signaled last spring, right before the significant market correction that began at the end of April. This combo now points to possible downside ahead, once again.

The first one measures the percentage of companies getting upward earnings estimate revisions. This number is at or near peak levels, which means two things. First, it's going to be tough for the percentage of companies getting upward numbers bumps to go too much higher. Second, high expectations are built into stock prices, because investors still rely on Wall Street analysts' earnings expectations so much.

The second sentiment indicator tracks the performance of high-beta stocks against low-beta stocks. High beta stocks, of course, represent economically sensitive names like chip makers or basic materials stocks. They generally sell the kinds of things for which demand increases sharply when the economy is improving. Low-beta stocks are the steady-Eddie defensive names that sell consumer staples, like Procter & Gamble (PG).

Right now, high-beta stocks are outperforming low-beta stocks by one of the widest margins in a while. This tells us that investors are pricing in very high expectations for the economy, which is no surprise. Ever since Goldman Sachs (GS) economists lead the way in upping their economic forecasts several weeks ago, analysts, investors, and other economists have followed suit, baking in higher expectations to models and stock prices.

But here's the rub. When these two signals hit near-peak levels simultaneously, thereby confirming each other, the market can have a propensity and sell off. They both peaked last spring, right before the major correction that started at the end of April. Now, the catalyst for the sell-off may well be the Friday employment report. That date as the start of a sell-off is also supported by other technical analysis used by this hedge fund analyst.

Another factor in the mix here is the number of investors who waited until now to take profits from last year, to delay tax bills. There could be more of this kind of tax-related selling ahead, to add to any downside momentum that develops. The hedge fund analyst painting the bearish near-term picture, who never allows himself to be identified in public, thinks the near-term pullback starting at the end of this week could bring declines of 10% or more.

Assuming he's right, what should you do now? I wouldn't sell long-term positions. After all, the same hedge fund analyst predicting this sell-off also thinks the markets will close higher for the year. However, I would take steps to de-risk your portfolio. I'd cut back on trading positions in stocks, or options positions that would hurt you in a down market -- like naked short put positions. I'd also trim margin exposure.

Now, this fairly dramatic call for a sharp near-term pullback may turn out to be wrong, of course, even though this hedge fund analyst has a good record at these kinds of calls. But given the recent strength in the market since last August, it's hard to imagine stocks are going to just rocket higher from here. So de-risking your portfolio, stepping to the sidelines a little bit, and building cash probably won't hurt you that much -- even if this forecast turns out to be wrong.
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No positions in stocks mentioned.

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