This contrarian indicator suggests there's plenty of upside to come for US stocks

Photo: NASA via Getty Images

US stocks have been on a tear this year, adding to the amazing run since the depths of the global financial crisis.

The S&P 500 Index has rallied by 17.4% year-to-date, taking its gain since early 2009 to an amazing 295%.

Just look at the monthly chart below to see the scale of the current bull market compared to those in the past.

An improving global economy, still loose global monetary policy settings, low volatility and, more recently, the prospect of US tax reforms, have proven to be a potent mix, helping to push stocks to record-high after record-high one day after the next.

After such a mammoth run, the question many are now asking is just how much fuel is left in the tank to power the rally higher?

Is it a little or a lot?

While no one knows the answer for sure, this indicator from Bank of America Merrill Lynch (BAML) suggests there’s plenty of room for the market to run higher.

Source: BAML

It’s BAML’s Sell Side Indicator, a measure of Wall Street’s bullishness on stocks. The bank describes it as a reliable contrarian indicator, often predicting when US stocks are likely to fall and when they’re likely to rally.

“The Sell Side Indicator is based on the average recommended equity allocation of Wall Street strategists as of the last business day of each month,” BAML says.

“We have found, when adding a little math, that Wall Street’s consensus equity allocation has historically been a reliable contrary indicator. In other words, it has been a bullish signal when Wall Street was extremely bearish, and vice versa.”

So what is the indicator telling us today, a period when stocks just screeched to yet another record closing high late last week on the back of optimism on the progress of US tax reforms?

According to BAML, even after the enormous rally over the past eight-and-a-half years, the indicator still suggests that there’s further upside for stocks with investor euphoria not yet at the levels that have historically led to selloffs in the past.

“The S&P 500’s indicated dividend yield currently near 2% implies a 12-month price return of +11% and a 12-month value of 2932,” BAML says.

“Historically, when our indicator has been this low or lower, total returns over the subsequent 12 months have been positive 94% of the time, with median 12-month returns of +20%.”

So given current sentiment levels on Wall Street, it has historically led to strong gains in the past in a majority of circumstances.

Perhaps there’s plenty of fuel left in the tank in this bull market?

BAML’s end-2018 price target for the S&P 500 is currently 2,800 points, below the level suggested by the sell side indicator.

And while the indicator has been a useful tool for predicting market movements in the past, the bank also stresses that past performance is not an indication of future results.

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