A Contrarian's Dream Scenario

We have been pleasantly surprised with the strength of the stock market rally that started in March.  We’ve also been somewhat skeptical of its sustainability.  After all, the market has surged by more than 40% in less than three months. 

Still, we see more contrarian indications today that the rally may yet have legs.  The Financial Times reported this morning that “Investors Skeptical on Stock Market Rebound.”

The FT writes, “...Barclays Capital has revealed that just 17.5 per cent of the 605 investors interviewed for its quarterly FX investor sentiment survey - including central banks, asset managers, hedge funds and international corporate customers - think risky assets have further to rise. This is one aspect of a generally gloomy outlook for the global economy, which undermines optimism that ‘green shoots’ of recovery are starting to emerge.”

Contrarians like to see near unanimity in opinion…in order to bet the other way, of course.  As we have said in prior posts, investors tend to “talk their book.”  In other words, if they are bearish, this generally means that they have already done any selling they intend to do.  After all, why would they continue to hold positions they felt likely to fall?

An ideal buying situation would be one in which sentiment was negative and cash positions high.  And this is precisely the situation we see today.   Here are some other stats revealed by the Barclay’s survey:

• “Just 4.5% of respondents believe the trajectory of the global economy over the next year will be ‘V-shaped.’”  In other words, 95.5% are expecting the economy to be soft.
• “Six out of every ten respondents believed that the recent rise in equities is a ‘bear market rally’, indicating that global investors still have a large share of their funds parked on the sidelines in cash.”
• “91 per cent of investors were running positions that were ‘light’ or ‘average’ in terms of their risk limit or capacity. This leaves just 9 per cent whose positions are ‘large’ or ‘at limit.’”

 So, we see that the stock market is continuing to rise while the overwhelming majority of institutional investors remains on the sidelines, in cash.  This in unquestionably bullish.

We should reiterate here that we, along with the majority interviewed, continue to believe that the economy will be soft.  The damage done in 2008 does not get fixed overnight.   

But as bad as the economy is, did it justify a drop in the stock market of well over half?  Did half of the companies in the S&P 500 go bankrupt or have their earnings permanently impaired?  Obviously, the answer is no.  The financial sector represented nearly 20% of the index at the peak in 2008, and even if the entire sector were written down to zero, we would still have been well above the March 2009 lows.  We should also remember that, even at the 2007 peak, the the S&P 500 was not overvalued by traditional metrics such as price/earnings and price/book ratios.  It went from being roughly fairly valued to being grossly undervalued.

The market's collapse was not due to economic fundamentals, per se, but due to a meltdown in the financial system itself.  It was a good, old-fashioned panic.  And with the panic stage passed, the market had (and perhaps still has) ample room to run, despite the fact that the underlying economy remains weak.  

Bottom line: We would expect global stock markets to defy expectations of collapse and continue their bull run.   Investors will eventually have to put their large cash holdings to work.  When they do, it could be like pouring gasoline on the fire.  

Charles Lewis Sizemore, CFA
www.charlessizemore.com

Check out Charles's new book, available on Amazon.com:  Boom or Bust: Understanding and Profiting from a Changing Consumer Economy

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