How Skepticism Can Fuel a Rise
By E.S. Browning
The Wall Street Journal Online
The stock market has been in a surprisingly strong rally since the middle of July -- so strong, that many experienced investors find it too good to be true.
Ironically, that very skepticism could be one of the reasons the market is doing so well.
"Some of the best market advances seem to be the ones that are the hardest to believe, and this one is hard to believe," says Paul Desmond, president of research service Lowry's Reports in North Palm Beach, Fla.
Mr. Desmond was one of many analysts who saw signs during the summer that stocks were running out of steam and heading for more declines. The decline that began in May looked like it could last a while.
But by mid-July, with broad stock measures down less than 10%, stocks suddenly turned higher. In August, Mr. Desmond says, he decided the rebound was for real and started sending alerts to clients, urging them to buy more stocks. Yet, many experienced investors remained doubters.
"We keep getting calls, especially from our older clients, saying, 'I am deathly afraid of waking up and getting a 30% decline.' We are telling them that we think there will be plenty of warning signs before something like that happens," Mr. Desmond says.
"It is taking a very long time for people to believe in the rally," says Phil Roth, chief technical market analyst at New York brokerage firm Miller Tabak. "It is just hanging on and hanging on."
The doubters, of course, could be right, and you would think that all this skepticism would be bad for stocks. If a lot of smart people don't believe in the rally, how can that be good?
That's where the irony comes in. Stock rallies often happen when the market is full of doubters. Those are times when money managers and individuals alike have pulled money out of stocks and are holding cash, bonds or other investments. If the market begins to turn up, these people start to feel left behind. They have money available to shift into stocks, and they do so.
As long as doubters remain to be converted, money can keep moving away from other investments and into stocks, pushing prices higher.
Once the great majority is bullish, however, things are different. Froth appears, as it did during the 1990s. Instead of holding money on the sidelines, people borrow against their homes or from their brokers in order to invest. That is when stocks can be at risk, because there is little free money left on the sidelines to move into stocks.
What interests some analysts is that the market still doesn't seem frothy, even though the Dow Jones Industrial Average is up 14.9% since July 14 and has racked up 18 record finishes since October began, and even though the Nasdaq Composite Index is up 21% since July 21 and near a six-year high.
"The reason the advance has persisted is that traders, especially hedge funds, just got very bearish in the summer. They have been very reluctant to reverse their opinion. Now they are getting carried, screaming, into the market," Mr. Roth says. What he means is that they are buying stocks against their better judgment, for fear of being left behind by competitors. Until more of them give in and turn bullish, he adds, the market is likely to keep rising.
Bearish investors -- short sellers -- are throwing in the towel. These are people who borrow stock and sell it in the expectation that they can profit by buying it cheaper later. After all the gains, they are "covering" their bets by buying the stocks back, often at a financial loss. "I am seeing short-covering every day," Mr. Roth says.
Gauging market mood isn't easy, but analysts have various ways to do it. The indicators they look at show a big swing from rank pessimism in the summer to more investor optimism today. In general, however, the indicators still aren't showing excessive optimism. With these indicators, investor doubts are considered positive for stocks, and excessive optimism is considered a sign of possible trouble ahead.
A measure of short selling on the New York Stock Exchange shows that the practice remains widespread, suggesting that plenty of pros doubt the recent gains -- not much optimism there. A survey by the American Association of Individual Investors shows the percentage of bulls has risen sharply since summer, but remains only a little over 50%, still in a range analysts consider neutral.
A survey of market newsletter writers by a newsletter called Investors Intelligence shows slightly more bullish results -- about 2.5 times as many bulls as bears. That is just on the threshold of trouble, in Mr. Roth's view, but not yet into worrisome territory. A poll of futures traders by Consensus Inc. has begun to flash a warning signal, with more than 70% bulls.
None of these numbers, with the possible exception of the futures-traders poll, is extreme enough to worry most analysts. They suggest that the rally is aging, but not that it is ending.
What's more, investors tend to get more bullish at year's end, because the period from Thanksgiving to New Year's historically has been one of the best for stocks. So a higher level of bullishness now is to be expected.
Not everyone is relaxed about the outlook. Merrill Lynch investment strategist Richard Bernstein, long a market skeptic, says he sees signs of froth. One of the best indicators of the market outlook, he says, is his measure of the bullishness of other Wall Street strategists. Currently, he says, the indicator is showing too much bullishness, and flashing a warning signal.
More generally, he says, professional investors are showing high appetites for risky investments and aren't using the kinds of hedging strategies he would expect to see if they were worried about the market outlook. He says the recent market gains are due, not to the conversion of market skeptics, but to the plunging price of gasoline, which has boosted optimism about inflation, interest rates, consumer spending and the economy.
"People are still risk takers," he says.
But that isn't the prevalent view right now.
Analyst Ned Davis, founder of Ned Davis Research in Venice, Fla., says he is "on the lookout" for a bear market, "but I doubt it will happen until sentiment gets to extreme optimism." And that, he says, hasn't happened yet.
Some once-skeptical analysts have been turned into believers. Louise Yamada, former head of technical research at Citigroup's brokerage arm, who now runs her own firm, saw the market heading lower earlier this year. Now the rally seems so strong that she sees the Dow industrials pushing above 13000, perhaps far above that level.
"The important thing is to look at the flow of money into and out of market," says Mr. Desmond of Lowry's. And there, he says, there is every sign that money is continuing to move off the sidelines and into stocks.
Write to E.S. Browning at
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