A bull market in pessimism

12/29/2008


Stocks remain choppy, with the Dow Industrials and S&P 500 Index trading in a narrow range over the past two weeks. Partly because late December and early January are typically bullish periods for the stock market, a near-term downturn in the averages would be discouraging.

With the Dow Theory in the bearish camp, holding a sizable portion of equity portfolios in short-term reserves seems prudent. We’re keeping 34% of our Long-Term Buy List and 32.5% of our Focus List and Buy List in Vanguard Short-Term Investment-Grade ($9.65; VFSTX), a relatively low-risk bond fund.

The January indicator
By definition, the stock market bottoms at the point of maximum bearishness. Some argue that point was reached Nov. 20, when the Dow Industrials closed at the lowest level since 2003. Surveys of investors have shown some increase in bullishness since Nov. 20, but sentiment remains very pessimistic.

Among investment newsletters tracked by Investors Intelligence, 47% are bears and 27% are bulls — one of the more pessimistic readings since 1990. The American Association of Individual Investors survey pegs bullish sentiment at 41%, up from a month ago but below historical norms.

Bulls argue that sentiment can only improve, if only because news regarding the economy and financial markets could hardly be worse. But history suggests market action tends to determine sentiment — not the other way around. So, especially with stocks entering a typically strong time of year, renewed market weakness could be enough to trigger another drop in bullishness.

Historically, the 10-day period starting around Christmas Eve has been among the best periods for stocks, partly because investors anticipate an infusion of cash into retirement accounts in the New Year. If stocks fail to rally during this period, it could be a sign that any such infusion will be meager this year.

Similarly, because January is a strong month for stocks, a failure to advance in January will be seen as a bearish omen. Since 1950, in years when the Dow Industrials have rallied in January, they’ve gained 9.8% from February though December, according to Ned Davis Research. In years when the Dow fell in January, it has gained only 1.6% in the remaining 11 months.

Conclusion
The market’s recent ability to shrug off discouraging news provides some grounds for optimism, but price action in January is likely to be revealing. Weakness in early January would be a bearish development, and a breakdown below the Nov. 20 closing lows of 7,552.29 in the Dow Industrials and 2,988.99 in the Dow Transports would reconfirm the bearish primary trend.


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