Here's the Indicator Some of Wall Street's Smartest Contrarians Use -- and Right Now It's Flashing Brightly

You won't have to look hard to find reasons to be pessimistic about the stock market's prospects. Inflation is rising. Some experts warn that Iran's disruption of traffic flowing through the critical Strait of Hormuz could lead to even higher oil prices in the coming months. Stock valuations are at record highs.

But many of Wall Street's smartest contrarians use an indicator that's flashing brightly. And this indicator could mean that right now is a great time to buy stocks.

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Bad is good

What is this positive indicator? The University of Michigan's Consumer Sentiment Index. This index, which has been used to track how American consumers feel about the economy since 1952, recently set an all-time low record. The Consumer Sentiment Index is even lower than levels seen during the worst recessions of the past 74 years and the scary early days of the COVID-19 pandemic.

You might be wondering how such a seemingly bad result for this index could be viewed as good news by investors. The answer is simple: The Consumer Sentiment Index is usually a lagging indicator rather than a leading one. In other words, it reveals more about what has already happened than what is likely to happen in the future.

Fisher Investments, a financial advisory firm founded by billionaire investor Ken Fisher, recently published an analysis of consumer sentiment and stock market returns. The company found that low Consumer Sentiment Index readings didn't predict 11 of the last 12 bear markets because stocks had already plunged.

Dismal consumer sentiment is often a predictor of a surging stock market. For example, the University of Michigan's Consumer Sentiment Index hit its second-lowest level to date in late 2008. One year later, the S&P 500 (SNPINDEX: ^GSPC) had soared roughly 36%. In July 2022, the Consumer Sentiment Index reached its all-time low. Fast-forward to 12 months later. The S&P 500 was up 16%.

Is this time different?

But could the record low Consumer Sentiment Index actually be a harbinger of trouble ahead this time instead of a roaring stock market? Maybe.

For one thing, in most past cases where the S&P 500 took off after consumer sentiment bottomed out, the stock market had already declined significantly. That's definitely not the case today.

Also, the lone outlier in Fisher Investments' analysis of the last 12 bear markets occurred during a period when inflation was a major concern. The biggest worry for consumers in the University of Michigan's latest consumer survey was that inflation would continue to rise.

Sometimes, low consumer sentiment merely reflects past and present economic difficulties for Americans with no bearing on the future. However, with the real prospects of higher inflation over the next 12 months, this time could be different.

Keith Speights has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.