Fear: A Healthy Sign for Stocks

10/14/2016 9:00 am EST

Focus: STOCKS

John Boyd

Editor, Fidelity Monitor & Insight

Legendary investor Sir John Templeton summed up the life-cycle of market advances as follows: “Bull markets are born on pessimism, grown on skepticism, mature on optimism and die on euphoria.” In other words, skepticism, or fear, is good for the health of bull markets, suggests John Boyd, editor of Fidelity Insight & Monitor.

We are now in the midst of the second-longest bull market in history, yet investors remain quite skeptical. Data from the Investment Company Institute, shows that investors have pulled $84 billion out of domestic stock funds and ETFs since the beginning of the year.

And they are not optimistic about the future, either. In the weekly survey conducted by the American Association of Individual Investors (AAII), the percentage who believe the stock market will be higher in six months has been below the long-run average of 38.4% for 79 of the past 81 weeks.

In their most recent survey, only 24.0% were bullish. That level is more than one standard deviation below the long-run average.

Since AAII started the survey in 1987, when bullishness has been that far below the average, over the next six months the stock market has moved up 80% of the time with an average gain of 6.9%. Over 12 months it has been positive 84% of the time with an average gain of 12.9%.

Importantly, it’s not just individual investors who are fearful. Merrill Lynch’s “Sell Side Indicator,” a measure of sentiment on Wall Street, fell to its lowest reading in more than three years.

Let me say right up front, I have no idea how much longer this bull market has to run. But there are a couple of signs that we should expect to see as its demise finally approaches.

If this bull follows the typical path, we should expect to see a strong upward move at some point that has investors rushing into stocks again with bullish sentiment well above average.

In Templeton’s words we should see “euphoria,” or in Allen Greenspan’s, “irrational exuberance.” This would be reflected in much higher P/Es. Over the past couple of years, the P/E of the S&P 500 has risen from 18 to about 21.

But, according to Zack’s Investment Research, the average P/E at the last six bull market tops was 30. If the market was trading at 30x earnings now, the S&P 500 would be at 2945 or 36% higher than today.

Not surprisingly, the end of bull markets tends to be accompanied by an economic recession. While parts of our economy are in contraction now (i.e. manufacturing) other parts are quite strong (i.e. labor market).

On balance, our economy remains stuck in a low-growth rut, but the recent sequential trend is improving — not worsening.

Second-quarter GDP growth was just revised up to 1.4%; still quite sluggish, but better than the first-quarter’s 0.8% pace. And the Atlanta Fed’s GDP Now model projects growth of 2.4% for the third quarter.

A traditional warning sign of an impending recession is an inverted yield curve. Normally, longer-term interest rates are higher than shorter-term rates because your money is at risk for a longer period. When a yield curve inverts, short rates are higher than long rates.

A good measure of this is the spread between the 10-year and 2-year Treasury yields. This typically turns negative before a recession arrives. Currently the spread is 81 basis points (0.83%) — low, but still positive. Bottom Line: Moody’s
Analytics puts the probability of a recession in the next six months at 13%.

Overall, we could face some turbulence this fall around the Fed’s stance on interest rates and the outcome of the presidential election. But the conditions for the end of the bull market are simply not present yet, so ignore the short-term swings.

Subscribe to Fidelity Monitor & Insight here…

By John Boyd, Editor of Fidelity Insight & Monitor

Related Articles on STOCKS

Keyword Image
11 Reasons to Buy Microsoft
18 hours ago

For our latest recommendation, we revisit one of the world's most prominent technology companies, Mi...

Keyword Image
A Trio of Top-Tier Biotechs
18 hours ago

We hold three biotech stocks in our growth portfolio — Biogen (BIIB), Bioverativ (BIVV), and R...

Keyword Image
Saudis, Oil and ETFs
18 hours ago

Under the guise of clamping down on “widespread corruption,” Prince Mohammed bin Salman ...