When Bears Hunt in Packs

06/13/2011 10:57 am EST

Focus: MARKETS

Igor Greenwald

Chief Investment Strategist, MLP Profits

The pessimism currently rampant on Wall Street has led to big rallies in the past, writes MoneyShow.com senior editor Igor Greenwald.

This is a pathetic market, so miserable and despised it might as well have been caught sexting Bambi.

The Dow went up 75 points Thursday for its first gain in seven tries, only to skid 172 points the next day. Nothing tortures the tormented like occasional glimmers of hope.

There was absolutely no buying interest Friday from the many money managers confident in the market’s long-term value. They can reasonably expect even bigger bargains later in the summer. Everyone’s looking at the same charts, and the market looks like it might have jumped the shark back in April.

The subsequent decline and fall split neatly into two parts.

  • In May, dips were stubbornly and persistently bought, so that by month’s end the S&P 500 sat just 1.4% from April’s post-Lehman high.
  • But June brought homelier economic stats, and all the dip buyers suddenly had pressing engagements elsewhere.

This month’s 5.5% setback for the S&P would be even worse without the outperformance of defensive sectors. Over the last month, rainy-day plays like health care, REITs, and energy pipelines have outperformed, masking the rush for the exits out of office supplies and networking equipment (down 15% apiece).

Perhaps the next jobless lot will be notified orally, in the interest of cost saving. But notified they will be, judging by the recent action in airlines, casinos, and appliance makers.

Is there any hope left for those not shorting Chinese stocks? Of course there is, because it’s probably not too late to get in on that game.

And also because on Thursday, the weekly American Association of Individual Investors sentiment survey registered fewer than 25% bulls on the stock market’s prospects over the next six months, and nearly 48% bears.

The bovines haven’t been this endangered since last August, when they briefly grazed below 21%—just before Ben Bernanke floated his plan to buy more bonds. By the time their numbers had trebled to 63% four months later, the S&P 500 had jumped 19%.

Now the S&P sits only marginally higher than during optimism’s December heyday, but has picked up a lot of downside momentum. Another moderately lousy day would test the (still ascending) 200-day moving average. And if that fails to hold, they’ll hold a touching wake for equities on all the channels.

NEXT: Bulls Riskier than Bears

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Bulls Riskier than Bears
But the lengthy track record of the AAII survey suggests there’s a lot more risk in a market crowded with bulls then in one dominated by bears. Between 1987 and 2004, there were 40 instances where bearishness was two standard deviations above the mean, which is roughly where we now stand.

From the depths of such funks, the S&P 500 averaged a gain of 18% over the next year, according to this study .

In fairness, it should be noted that, a year after bullish extremes like that seen last December, the S&P 500 averaged a loss of 5.5%. So maybe there are more tough times ahead, followed by a rally in 2012.

But I can’t shake an eerie sense of déjà vu dating back to the last instance of over-confidence to match December’s, which came in November 2004.

Then, in the immediate aftermath of George W. Bush’s landslide re-election, all sorts of cherished investor dreams seemed possible (“Let’s privatize Social Security!”) This was 18 months into a bull market.

Predictably, five months later, the S&P 500 reclined 4% lower and the percentage of bulls had shriveled from 64% to 16.5%. I found a market story from the day after sentiment bottomed in April 2005, and here’s what it had to say:

  • “Deepening concerns over economic growth and higher prices led to the worst week of trading since August…after the Federal Reserve reported drops in manufacturing and other industrial production…”
  • “Many analysts [are] predicting a shift in investing trends, away from commodity-driven issues toward…health care and consumer staples…”
  • “Put simply, economic growth is not going to be nearly as strong this year as it was expected to be…”
  • “Earnings are really the only hope for this market. … If, on the whole, earnings can go up, then we might be able to overcome oil and inflation and all the other things.”

Six days later, the same source was reporting breathlessly on stocks’ “stunning rebound.” Three months later, the AAII bulls were back up to 57%, and the S&P 500 was 9% above its April low.

The “soft patch” proved to be just that. Corporate profits didn’t come undone.

Lowering the Bar
That’s not to say that this is necessarily how things will play out this time. We’ve used up a few “get out of jail” cards since 2005, and seem to be in a good deal more trouble.

But the market is a discounting mechanism, and the bearishness, cynicism, and outright defeatism in place today would suggest that it has discounted quite a few collective fears—starting with the possibility that this is more than just a mid-cycle slowdown.

It’s also hard to be bullish when many, perhaps most investors believe their government and central bank are pursuing disastrous policies.

This is not a mindset I share. But I do think it explains both the shrinking valuations of the present day and the potential for a sentiment shift in the near term.

Given what most investors think, things don’t need to go great from here for stocks to pay off. They just have to stop getting worse. The bar has been lowered to a position that has proven profitable more often than not in the past.

It’s not clear what the catalyst for a turnaround might be. A US budget deal, solid earnings, or a big merger could all be mood changers, as would Muammar Gaddafi’s ouster and a subsequent decline in oil prices.

But with so many bears on the loose, there’s no need to guess. Something should turn up soon enough.

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