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Last Friday, I suggested looking at US stock market valuations because they were back to the attractive levels of July 2009. (“It’s Time to Look at Stock Valuations” – June 25.) That was a fact-based analysis. Today, let’s add in the psychological side, then blend the two together.

Today’s Psychological Stock Market Trend

Most investors understand what stock market trends are, but not necessarily what causes them. These movements can be based not only on fact, but also on belief and emotion. Belief and emotion are psychological drivers and, when they take over, an interesting dynamic occurs. Theory, commentary, selective analysis and powerful visions can overwhelm facts. These trends run as long as more investors keep being attracted to the bandwagon.

I believe the weakness in today’s US stock market has become a psychological trend. It started with April’s confluence of negative events, then mushroomed into pessimistic visions of economic/financial collapse (or, at least, a double dip) that will lead to a dramatic fall in the stock market.

However, a psychological trend doesn’t have the staying power of a factual one. There are two major causes of a psychological trend’s end:

  1. New investors joining the movement dwindle, typically because time passes and the expected results don’t materialize
  2. The trend takes valuations too far from reality, sparking a countertrend driven by other investors taking advantage of the disparity

The second situation is where I believe we are today. It can produce a strong reversal as the use of proven, long-term valuation measures returns.

Testing the Psychological Trend: What Would It Take to Surprise Bearish Investors?

In the Wall Street Journal, two articles approached today’s stock market valuation from the psychological perspective. They each discuss investors’ current negative views and then wonder what might happen if coming earnings and economic reports don’t reveal weakness.

From the first article, “Will Earnings Surprise the Bears? With Companies Optimistic About Second-Quarter Numbers, Battered Stocks Have Room to Rise” (Abreast of the Market, by Peter A. McKay, June 28, page C-1):

Lately it seems nothing can cheer up stock investors. Even last week, a rally set off by China’s decision to loosen control of its currency fizzled within hours.

Now some analysts are looking to the end of the second quarter and the coming earnings season and wondering if investors have gotten a little too bearish.

In particular, many investors are weighing companies’ apparent confidence in their earnings forecasts against the market’s recent weakness — a combination that some say could leave room for gains when companies begin announcing earnings in a couple of weeks.

From the second article, “Investors Hunt for Clues in Coming Data” (Ahead of the Tape, by Kelly Evans, June 28, page C-1):

As the ugly second quarter draws to a close this week, markets are worrying the second half won’t be much better.

But savvy investors know, as Warren Buffett says, to be greedy when others are fearful.

While positive developments on all fronts should ignite a rally, a few pieces of good news might be enough.

In other words, psychological drivers appear to have moved the stock market well below its valuation based on known and anticipated facts. Therefore, the risk is now favoring the stockholder – meaning that even satisfactory news could jolt bearish investors.

What Has Been Happening to Earnings Forecasts?

The table below shows how the 2010 earnings estimates have shifted for the Dow Jones Industrial Average’s (DJIA’s) 30 companies. Listed are the forecasts at three dates: February 26 (following the 4th quarter 2009 reports), May 28 (following the 1st quarter 2010 reports) and last Friday, June 25. The percentage changes are then given.

(Click to enlarge)

Notice that the overall increase due to the good 1st quarter reports was a high 3.4%. Since then, there has been only a slight trimming of -0.2%. Does this mean analysts are overly optimistic? No, for three reasons:

  1. Analysts are judged by their accuracy, so they work at getting their estimates right.
  2. The market climate has yet to heat up, so analysts remain careful and objective.
  3. Analysts know well April’s negative events and the potential impact on the companies they evaluate.

In other words, the estimated earnings can be used as a sound basis for stock market valuation. Yes, the estimates could be proven wrong – that’s the nature of trying to predict.

BUT (and here is the very important point for pessimistic investors who believe conditions will prove worse than forecast) –

The stock market (as measured by the DJIA) is selling at a price/earnings ratio of only 12.5 times 2010 estimated earnings (equal to an 8% earnings yield). And, with 15% earnings growth predicted for next year, the 2011 price/earnings ratio is only 10.9 (equal to a 9.2% earnings yield). Moreover, in about two months, Wall Street will start focusing on those 2011 numbers in earnest for valuing the stock market.

Using risk as a reason for underweighting, selling or shorting the US stock market with these valuations carries high risk. While some commentators have mentioned the possibility of the market falling 20% or more, such a drop would require a commensurate decline in earnings estimates.

So… Bearish investors need to tread carefully in this stock market. The very attractive valuations make betting against the market especially risky. The coming second quarter earnings are a significant test for the bears.

Disclosure: Client positions include AA, BA, CAT, KO, XOM, INTC, MRK, WMT

Source: U.S. Stock Market’s Trend About to Be Tested