Sunday, November 21, 2010

Optimism Reigns

   As we head into a shortened week due to the Thanksgiving holiday, it seems unlikely that market volumes or volatility will be too high. After last week's dramatic decline and massive rise that ultimately moved markets very little, reduced volatility may be a welcome change for many investors. With the final month of the year approaching and many expecting a Santa Clause rally to take hold soon, it appears markets are poised for another year of double digit gains.This news may come as a surprise given that much of the talk the past few months has been about the wall of worry surrounding stocks. Although this talk has been common practice amongst market participants, it may not hold real weight in the investment community.

   A commonly used phrase I'm sure you've heard is that "talk is cheap." One thing I've certainly learned in my lifetime is that words only really matter if a person's actions back them up. These past few months it appears that much of the cautious or negative talk on Wall Street has been just that. A survey of big fund mangers by Bank of American Merrill Lynch recently showed "market sentiment at its most bullish since April 2010." For those who don't recall, April marked the previous highs for the year before fears of European sovereign debt caused equity markets to drop over 15% within several weeks. Although this level of bullishness could be cause for concern, as long as funds are sitting on loads of cash there should still be room to run. Unfortunately, this does not appear to be the case as average cash holdings fell to only 3.5%. If these surveys truly represent large funds on the whole, one has to wonder where future gains will come from.

   Although large investors and funds may already be largely invested, there remains hope that individual investors will finally succumb to recent stock market gains, jumping out of bonds and back into stocks. This shift in allocation is viewed as a potential driver for the next leg of the bull market rally. However, the American Association of Individual Investors (AAII) Sentiment Survey recently found 58% of investors bullish, the highest reading since the market topped out in 2007. While equity fund outflows may continue, given the degree of bullishness in the market, it remains unclear what level would need to persist to bring money back into equities. For anyone who remembers the past few bubbles, it is typically the individual investor that got to the party last. Therefore, any sign this group is coming back to stocks in a meaningful way may be a good sign that the rally is almost over. 

   As the title of this blog suggests, I'm a clear believer that our future economic path will be largely defined by more frequent bubbles and bursts. Given my weak outlook for the real economy, equity markets appear to be setting the foundation for the next bubble. Though this may play out over a couple years, recent bullishness and market gains suggest a pullback may be in order. Despite the nearly 3% drop a week ago, a more meaningful pull back of 5-8% is likely necessary to move sentiment back to typical levels. 

   I've listed a few articles below related to the topic discussed and from which some of my data was found. The articles are listed in order of preference given any time restraints or desire by the readers...enjoy.

The Cliff by John P. Hussman, Hussman Funds
Market Optimism Is Ominous Sign by Breet Arends, Wall Street Journal
Smart Money Is "Selling the News" by Ron Coby, Minyanville 

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