A Rally With Few Believers

3/12/2012


Major stock indexes have erased most of their 2008-2009 declines, but not the painful memories of that turbulence, as individual investors remain somewhat reluctant to participate in the rally.

The Dow Jones Industrial Average and S&P 500 Index have climbed to their highest levels since mid-2008. Yet equity mutual funds have experienced net inflows in just two of the last five weeks, according to Lipper. Even corporate insiders sold shares of their own companies last month at the heaviest rate since May.

About 44.5% of individual investors were bullish at the end of February, according to the American Association of Individual Investors, above the long-run average of 39% but down from 49% in the first two weeks of January. The AAII says sentiment tends to peak ahead of the market, and market tops tend to form when bullish sentiment nears 60%.

Newsletter editors are more optimistic than individual investors. According to Investors Intelligence, 47.9% of editors are bullish, down from four consecutive weeks above 50%, the threshold where exuberance starts to become dangerous. Investors Intelligence has identified that major market tops generally occur when bullishness exceeds 55%. More advisers are hedging their outlooks, with the percentage of analysts calling for a correction rising to nearly 26%, the highest level since August.

To test the value of sentiment as an indicator of future performance, we considered more than 10 years of weekly data for both individuals and advisers. For example: In the three months following periods when 45% to 50% of newsletter editors were bullish, the S&P 500 Index rose 53% of the time and declined 47% of the time. In contrast, after the 101 weeks when 40% to 45% of advisers were bullish, the market rose 68% of the time. Given that the index rose in 60% of the three-month periods, we can conclude that 40% to 45% bullishness is a modestly positive indicator, while 45% to 50% is slightly negative.

In general, low adviser bullishness is good for stocks, although the relationship is far from perfect, as shown in the table below.

Bottom line: While investors should pay attention to sentiment indicators, sentiment trends on their own are not sufficient to support buy or sell decisions.

SENTIMENT AND STOCK RETURNS
----- 3-Month Return -----
----- 12-Month Return -----
No. Of
Periods
% Up
% Down
No. Of
Periods
% Up
% Down
Newsletter Editor Bullishness
35% Or Lower
42
57
43
40
68
33
35% To 40%
61
61
39
51
71
29
40% To 45%
101
68
32
92
65
35
45% To 50%
131
53
47
121
63
37
50% To 55%
127
54
46
113
58
42
55% To 60%
92
71
29
84
89
11
Above 60%
12
42
58
12
67
33
Individual Investor Bullishness
25% Or Lower
26
77
23
25
72
28
25% To 30%
52
52
48
45
60
40
30% To 35%
93
61
39
84
57
43
35% To 40%
112
53
47
94
71
29
40% To 45%
98
58
42
89
69
31
45% To 50%
74
62
38
72
69
31
50% To 55%
50
66
34
45
67
33
55% To 60%
35
57
43
34
79
21
Above 60%
26
69
31
25
56
16
Total Periods/Avg.
566
60
40
513
68
32


Growth impediments

Bears have no trouble finding new bricks to build their wall of worry. Even as markets marched higher, Advisors Sentiment noted that "newsletter editors failed to increase their optimism, and in fact strongly bullish comments were difficult to find. Instead there were repeated references to overbought conditions and that a pullback was overdue."

"I am sensing something big and ominous in the offing," says Richard Russell's Dow Theory Letters. "The roof of a monster top is building," though that might be the least of our worries if his prediction of a nuclear war between Israel and Iran comes to fruition.

Economic improvement

Fortunately, not all the news is bad. Europe remains a risk, but some of the financial stress appears to be abating. Meanwhile, corporate profits were fairly strong in the December quarter, with the S&P 500 Index growing per-share earnings 9%. The consensus calls for the index to grow earnings 8% in 2012, a target that may not reflect the economy's true rebound potential.

The Blue Chip Economic Indicators February consensus projects economic growth of 2.2% in 2012, a target that has held steady for the last three months. The unemployment-rate forecast is 8.3% for 2012 and 7.9% for 2013, with both estimates down from the previous month.

Housing starts and building permits are on the rise, as are sales of existing homes. An improving construction environment could help the labor market continue its steady — if modest — improvement. The construction industry shed 2.3 million jobs in the recession, roughly 25% of all jobs lost.

Conclusion

While individual investors have justifiably mixed feelings about the market, their lack of enthusiasm suggests that plenty of money remains on the sidelines. A near-term correction will probably keep individual investors skittish. But if investors take the plunge, stocks could still rise higher than current levels.


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