How Skepticism For a Rally Ends Up Fueling It

by: Barry Ritholtz

Terrific article in today's WSJ by E.S. Browning on how disbelief in a market move can actually be a cause of that move going even further:

"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."

How does that change once the sentiment begins to shift to excessively bullish?

"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 column also quotes a who's who of technical and quant luminaries:

-Paul Desmond, president of research service Lowry's Reports
-Ned Davis, founder of Ned Davis Research
-Louise Yamada, former head of technical research at Citigroup's brokerage arm
-Phil Roth, chief technical market analyst at New York brokerage firm Miller Tabak.

The article specifically notes "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." That short covering is part of the fuel for the move higher.

Investor pessimism over the summer has morphed to a more optimistic outlook of late. And, the column notes, "indicators still aren't showing excessive optimism."

That contrary indicator, plus the overall market momentum, has been
why I have been steadfast against shorting this market since the June lows. Investors should
never step in front of a locomotive, and must always wait for a
technical signal prior to going short on a macro basis.

Paul Desmond added:

"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."

Investors need to be patient, waiting for those signs . . .