This Signal Just Flashed for the First Time in 8 Years; History Says It Could Indicate a Sharp Correction Ahead

While long-term market returns are based on fundamentals, short-term returns can be heavily driven by sentiment and momentum. If investors are feeling good, they can help drive up equity valuations and ignite a lengthy stock market rally.

The artificial intelligence (AI) boom has helped deliver three straight years of double-digit returns for U.S. stocks. That's not only boosted market sentiment significantly, it's also pushed it to levels rarely seen in history.

Bank of America recently released its latest global fund manager survey, which includes the popular Bull & Bear Indicator. The report's findings show that indicator hitting 9.4 in January, considered "hyper-bull" territory, and marking the highest level it's reached since January 2018.

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Why 2018 is important in connecting overconfidence to stock market declines

The year 2018 provides a classic example of how bullishness can translate directly to certain trading behaviors that ultimately burn investors. In 2017, the S&P 500 (SNPINDEX: ^GSPC) rose by around 20% and continued to tack on additional gains in early 2018. This was the time around which the Chicago Board Options Exchange Volatility Index, or VIX, was at historically low levels, often tracking in the high single digits for extended periods.

Investors began selling volatility-linked futures contracts, betting that the low volatility environment would continue. It was a money-making trade as long as the VIX remained low. But soon, volatility would return.

In February 2018, "Volmaggedon" happened. Volatility suddenly spiked and sent the VIX to 50 in a matter of a few trading days. The short volatility trade blew up and the S&P 500 fell 10%. Investor overconfidence led to a sudden market shock that resulted in a swift and sharp correction in stock prices. A historically high reading in the Bull & Bear Indicator preceded this event by mere weeks.

Other examples where the Bull & Bear Indicator has signaled trouble

The indicator also signaled oversold conditions in February 2020. This, of course, was right before the COVID-19 pandemic began shutting down the U.S. economy and the S&P 500 cratered by more than 30% by March.

The Bull & Bear Indicator also flashed an overbought signal multiple times in 2006 and 2007. This was also a traditional overconfidence signal as people believed home prices would continue rising. This led to extremely overleveraged conditions that eventually blew up in 2008, leading to a deep recession, a crash in the housing market, and a decline of more than 50% in the S&P 500.

Why a market correction could be coming

While the Bull & Bear Indicator isn't a flawless market correction signal, it does have a pretty good history of showing that investors are perhaps a little too bullish and leaving U.S. stocks vulnerable to a pullback.

2008 and 2018 are great examples of how overconfidence resulted directly in dangerous behaviors. Interestingly, the global fund manager survey also showed a historically high allocation to equities right now and historically low cash levels in portfolios. We might be heading down a similar path in 2026.

Bank of America is an advertising partner of Motley Fool Money. David Dierking 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.