While I take no pride in being the bearer of bad news so early in 2011, events are unfolding in the stock market that require immediate caution on the part of my readers. Specifically, an indicator I follow closely is flashing red for stocks.

Stock market sentiment—that’s how investors feel about stocks—has turned very bearish. Here’s how this indicator works:

The more positive investors feel about the stock market, the more bearish the investment sentiment indicator turns. The logic is quite simple: Stock market investors are usually wrong when as a group they feel that stocks will move in a certain direction, as the stock market always delivers the opposite of what is expected of it.

After a great 2009 and a good 2010, the prevailing consensus is that the worst is over for the U.S. economy and that stocks will have a great 2011. Nothing could be further from this consensus. The easy money in the stock market has already been made.

The S&P 500 is up 86% since its March 2009 low—the best rally for the S&P 500 in 55 years! I told my readers to get into stocks in March 2009 (and to stay in stocks right through 2009 and 2010), because the great majority of investors were avoiding the stock market. I was saying “buy” when everyone was selling or simply not interested in stocks. This is classic contrarian investing.

Going into 2011, it is a different story for me. Our in-house technical analysis expert, Anthony Jasansky, P. Eng., has just completed an excellent study for us in which he compares the sentiment reading of the American Association of Individual Investors, Investors Intelligence (a service that tracks the opinions of financial newsletters), U.S. corporate insider buying/selling, and the puts/calls ratio of the Chicago Board of Exchange (the entire group being known as sentiment indicators).

The bottom line: too many investors, advisors and analysts have turned bullish on the stock market. This is actually bearish for stocks. Remember, the stock market always does the opposite of what is expected of it. And the most popular group of sentiment indicators is flashing red for us as 2011 starts.

The headlines flashing across Bloomberg and CNBC are all too positive. Just a day ago it was, “GM, Ford, Chrysler U.S. December Sales Top Analyst Estimates,” “U.S. Manufacturing Expands at Fastest Pace in Seven Months,” and more.

Couple all of the positive economic news with the biggest stock market rally in 55 years and we are dealing with the reverse of what has happened over the past 22 months—the bear has been successful in luring investors back into the stocks for 22 months, as stock prices rose. In due course, as more investors turn bullish, the bear market will start to bring stock prices back down.

Investors will wonder, “How can the stock market be moving lower when the economy is getting better?” The stock market is a leading indicator. All the positive economic news we are hearing today was discounted by the stock market months ago.

The year 2011 will be treacherous for investors. I don’t expect to see the gains of 2009 and 2010 repeated. I do see the bear’s ugly head returning amid a sea of rising optimism. I’m ringing the warning bell early for my beloved readers: Tread with caution in 2011.

Michael’s Personal Notes:

According to Virginia-based American Bankruptcy Institute, 1.53 million Americans filed for bankruptcy in 2010—the highest amount since 2005 when the U.S. Bankruptcy Code was revamped by Congress.

While the U.S. Labor Department will report Friday that the U.S. created thousands of jobs in December of 2010, all is not well in America. Many Americans have given up looking for work (skewing the job numbers), the real estate market is not recovering, and there is a very strong possibility that one or more U.S. states will default on their debt in 2011 if a federal bailout of some states does not develop.

As I have written in my lead article today, I see events in motion that will have 2011 surprise on the downside.

Where the Market Stands; Where it’s Headed:

Immediate-term, I see the bear market rally in stocks that started in March of 2009 continuing. Short- to medium-term, I’m starting to turn bearish on the stock market.

What He Said:

“The U.S. reduced interest rates in 2004 to their lowest level in 46 years. And what did Americans do with their access to easy money? They borrowed and borrowed some more, investing the borrowed money into real estate. Looking ahead, perhaps the Fed’s actions (of bringing interest rates so low as to entice consumers to borrow more than they can afford) will one day be regarded as one of the most costly errors committed by it or any other banking system in the last 75 years.” Michael Lombardi in PROFIT CONFIDENTIAL, July 21, 2005. Long before anyone was thinking of a banking crisis, Michael was warning that the coming real estate bust would wreak havoc with the banking system.

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