- Despite the recent string of all-time highs, from a market psychology perspective, there is little reason to believe that stocks are peaking.
- This time is very different from previous peaks - Americans are currently much more pessimistic about the economy and about risk assets than they were in 1999 or 2007.
- A cyclical upturn in sentiment is likely to drive stocks to significant new highs in the next 12-18 months.
In my forthcoming 2014 outlook report, I will argue that it is quite likely that broad market indices such as the S&P 500 (NYSEARCA:SPY) and the Dow Jones Industrial Average (NYSEARCA:DIA) will experience major gains from current all-time high levels within the next 18 months. Indeed, I will argue that many equity sub-sectors will take on bubble characteristics and will double and triple from current levels.
There are many reasons why I believe that US stocks still have very significant upside from current levels, but one of them can be gleaned by analyzing a series of indicators of investor mood/sentiment highlighted in a recent thought-provoking essay by Peter Atwater, who is one of the keenest analysts anywhere on the subject of social moods and financial markets.
Interestingly, Atwater and I currently interpret these indicators in ways that are diametrically opposed. By analyzing our very different perspectives, investors can understand one of the reasons why I believe US equity prices may be in the early stages of bubble formation and eventual blow-off top.
For his part, Atwater cited various statistics that indicate that investor mood/sentiment is quite pessimistic/cautious in order to make the case that, "from a systemic resilience perspective, today's starting conditions are very different from both 2000 and 2007, and based on what I see, the market's confidence underpinnings, for lack of a better term, are far more fragile than they were at either of the past two market peaks." Atwater concludes from the weak sentiment underpinnings that "global financial markets are at risk" of major declines.
Below, I will paraphrase or directly quote some of the data provided by Atwater, along with his bearish interpretations, and follow it with my more bullish reading of the same indicators.
1. Atwater: In 2000, Gallup economic confidence was +30. In 2007 it was +10. Yesterday it was -18.
Kostohryz: The economic pessimism cited by Atwater here provides an excellent indication that the stock market is nowhere near a top. Indeed, according to just about every long-term metric of economic / financial sentiment - e.g. Gallup, University of Michigan, Conference Board - American economic confidence has been extremely depressed relative to historical levels since the 2008 financial crisis. Note that I am talking about long-term indicators of economic and financial sentiment as opposed to shorter-term indicators such as the AAII Sentiment Survey. Short-term sentiment indicators are of dubious reliability as contrary indicators, whereas longer-term indicators have had a better track record of providing clues about market trends. In this regard, long-term indicators of sentiment have been improving from depressed levels, but they are currently still well below levels associated with prior market peaks. Economic and financial sentiment works in cycles and it appears that "animal spirits" are still in an early stage of recovery from historic lows. Indeed, it is my view that as the US economy improves, and the 2008 crisis becomes a more distant memory, US economic and financial sentiment is poised for very significant gains from current levels. Improved sentiment will spur greater consumer and business spending, cause accelerated economic growth and provoke asset price increases as risk appetites increase in tandem with boosted economic confidence.
2. Atwater cites anemic trading volume as a bearish factor for stocks. Average NYSE trading volume: 2.6 billion shares in 2007 and 1.4 billion shares in 2013.
Kostohryz: There is no question that anemic trading volumes are indicative of pessimistic investor sentiment and depressed risk appetite. But this is a very good reason to suppose that we are nowhere near a market top. The extremely low stock trading volumes (despite the explosion in volumes coming from impersonal and sentiment-less algorithmic trading) show me that there is a great deal of scope for a renewed interest in trading/speculation in risk assets on the part of the public. If this occurs, as I believe it will, stock volumes and prices will be driven higher. Why do I believe that speculative interest will be re-awakened? Well precisely because it is not different this time. Human nature is rather stubborn. As the economy improves, risk appetites and trading volumes will likely surge, just as they always have.
3. Atwater: Trade-order has changed significantly. Thanks to smartphones and tablets, today's market participants have untethered access to real-time information and trade execution. Markets are mobile. There are no perceived barriers to execution. None.
Kostohryz: The ever-increased and virtually unfettered access of the public to stocks is an excellent reason to suppose that if sentiment improves from currently depressed levels (as I believe it will), stock prices could go ballistic. Impulsive buy orders used to be mediated by a phone call to brokers and discouraged by high commissions and fees. Today, there are no such restraints to impulse-buying when and if sentiment turns around and becomes more positive.
4. Atwater: In 2000, the US government had a budget surplus of $236 billion. In 2007, it had a deficit of $161 billion. Last year the deficit was $1.1 trillion.
Kostohryz: Deficits and debt are yesterday's news. The relevant news for the immediate future is that the US budget deficit is projected to decline to around 3% of GDP in 2014. This level of deficit means that the fiscal crisis in the US is effectively over for the time being - the US debt as a percent of GDP will actually start to decline with the deficit at these projected levels. And with the perceived end of this long-running fiscal crisis will come an end to all of the apocalyptic pessimism surrounding the US debt situation. The major reversal in the perception of the US's fiscal situation from one of despair to one of apparent sustainability is prospectively a hugely bullish development that should encourage increased investor confidence and concomitantly higher prices for stocks.
5. Atwater: In 2000, the Federal Reserve's balance sheet was roughly $500 billion in size. By 2007 it had reached $800 billion. Today it is $4.1 trillion.
Kostohryz: Excess liquidity, driven by the Fed's bloated balance sheet is hardly bad news for asset prices. This is the fuel in the tank that can drive US equities to historic heights. Excess liquidity cannot and will not drive asset values up in and of itself. However, excess liquidity combined with declining risk aversion and declining liquidity preference is a sure recipe for asset price inflation and higher stock prices. Put another way, record levels of cash on business and household balance sheets, combined with a diminished desire or perceived need to hold cash, will cause both businesses and investors to bid up the price of financial assets as they attempt to bring their cash levels down to more "normal" levels. The irony is that, on aggregate, they can't actually spend down the excess cash balances! When one business or household spends cash, it simply just ends up on the balance sheet of another business and/or household. And so, cash starts to become a sort of "hot potato" which everybody wants a bit less of (or feels more comfortable parting with in exchange for other goods). This is the classic inflationary dynamic, and it should be particularly pronounced as regards to asset price inflation as most businesses and households that have large amounts of excess cash will probably direct relatively more of it towards the purchase of investment goods than consumer goods.
6. Atwater: On the political front, Congress had an approval rating above 50% in 2000 (and reached an all-time Gallup high of 56% in 2001). In 2007, the approval rating was 27%. Today it is 12%, just above its record low 9% reached last fall. Last year Congress passed a record low 55 bills versus 180 in 2007 and 410 in 2000.
Kostohryz: Deep dissatisfaction with national leadership is just another contrarian bullish indicator for financial markets. First, just on a prima facie basis it is pretty clear from these numbers that there is a great deal of more upside than downside to sentiment in terms of public perception of US leadership. And the implication that I believe should be drawn from this is that there is considerable upside in terms of how US citizens are feeling about their country's leadership and the direction of the country in general. When was it a better time to buy stocks: During the later years of Jimmy Carter's "malaise" or during the feel-good years of Bill Clinton's second term?
7. Atwater: "A line of retail investors rushing for the exit and causing panic is not my major fear. Today, I am more concerned that a single large investor could create discontinuous markets; as the system moved, would it be able to accommodate others in size?"
Kostohryz: In my view, this is exactly the wrong focus. What reason is there at present for supposing that a single large investor is going to cause a break in markets at this time? Sure, it could happen, but there is absolutely nothing to indicate that such an eventuality is imminent, or even more likely today than at any other time. The more reasonable concern, it seems to me, relates to the fact that retail investors have been hunkering down in fear since 2008. This risk aversion by retail investors can be demonstrated in many ways including multi-year collapses in retail trading volumes as well as deeply depressed equity mutual fund inflows. The problem is that thanks to the Fed, retail investors today have more cash than ever, as indicated by record high deposits in savings accounts. Therefore, it seems to me that the real fear should be that these retail investors, flush with excess cash, are going to come back rushing to ENTER the market, driving up volumes and prices, putting to good use the wondrous technical ability of the brokerage system to handle enormous volumes of trading. So, the fear should not be that the financial system is vulnerable to the weakness of a major investor - the big financial players today are leaner and meaner than they have been in decades in terms of capital ratios and the basic efficiency and profitability of their operations. In my view, what we should really be concerned about is that the financial system will not really be able to generate enough new IPOs and tradable risk assets to accommodate the flood of cash that might be flooding into the market via retail investors without inflating a major bubble in the prices of the risk assets that trade on the stock markets.
Peter Atwater is one of the keenest observers of financial markets and the role of social moods. However, I think most of the negative indicators that he is observing have nearly the opposite implications from what he suggests.
Years of persistently depressed economic and sentiment and currently tepid attitudes towards equities that Atwater's data highlight tend to indicate that we are still in the early stages of a cyclical recovery in economic and financial sentiment. I believe this is true, even if Atwater and other analysts are correct that the US is in the midst of a "secular" decline in economic and financial sentiment. Secular trends don't preclude cyclicality. In terms of long-term cyclical measures of risk appetites and "animal spirits" the US stock market is a long way from the sort of sentiment exhibited during previous stock market peaks, much less during previous stock market bubbles. To the contrary, as I will argue in my forthcoming 2014 Outlook which I will provide to subscribers of my newsletter, the combination of a prospective cyclical upturn in economic and financial sentiment coming off of historic lows combined with excess liquidity in the economic system augers for significantly higher equity prices in the next 12-18 months.
This time is very different from 1999 or 2007 because Americans are currently much more pessimistic about the economy and about risk assets than they were at the time of those previous peaks.