Sam Stovall: Extreme Bullishness a Concern - Stocks Will Probably Correct

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 |  Includes: DIA, QQQ, SPY
by: Harlan Levy

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Sam Stovall is chief investment strategist at Standard & Poor’s Equity Research as well as the author of The Seven Rules of Wall Street and the column Stovall's Sector Watch, a page on Spoutlook.com.

Harlan Levy: How do you rate the jobs situation, and what are the implications for this year?

Sam Stovall: I was disappointed from a payroll perspective but was encouraged from an unemployment rate standpoint. What’s more I was encouraged to see a decline in the number of the underemployed, because it implies that the drop in the unemployment rate was not due to job seekers giving up in frustration.

However, the jobs situation is still the biggest impediment to the stock market’s performance in 2011. S&P Chief Econoist David Wyss continues to believe that unemployment will likely remain above 9 percent for all of 2011 and that this will remain a jobless economic and stock market recovery.

If, however, we find that the payroll picture improves more rapidly than anticipated, we believe the upward trajectory in economic and market performance will accelerate.

H.L.: The level of investor optimism about the stock market seems extreme these days. How bullish are you on stocks?

S.S.: I do think that the extreme level of investor optimism is something to be concerned about in the near term, but it does not stop me from being optimistic for the longer term. The recent spate of better-than-expected economic reports combined with the still strong forecasted increase in earnings supports the seasonal tendency for the S&P 500 to be strong in both the January and the first-quarter of a president’s third year in office.

That said, the stock market usually gives investors a second opportunity to get back in at lower prices. By that I mean since World War II 89 percent of the time the S&P 500 has been lower at some point in the new year as compared with the closing level of the prior year. Of course, past performance is no guarantee of future results, and this year’s market action might fail to take a breather, but I doubt it. So I don’t think it’s wise to be chasing returns right now, because nearly nine times out of every 10 the market in the new year trades about 9 percent below the closing level of the prior year.

H.L.: Has the stock market priced in the massive debts of the states and cities and towns?

S.S.: That’s a very good question. I’m not really sure. The market seems to go back and forth between fear and complacency as it relates to debt on a variety of levels, be it sovereign, state, local, or personal. When it comes to the states’ debts, they’re facing monumental obligations that they may have a very hard time fulfilling. California is certainly substantially larger than the economies of Greece and Ireland, and if you add Illinois to the equation, there would be substantial reason to be worried should these states default on their obligations.

Based on the absence of meaningful discussion of a potential default, that leads me to believe that the market does not expect default to be a likely outcome. I’m worried that we’re putting it on the back burner, but it’s obviously not affecting the market. It’s the outlook of the bears versus the outlook of the bulls. Bears focus on structural problems , things that take years to materialize, whereas bulls tend to look at nearer term events and basically say the trend is my friend until it ends. Chances are the bears will eventually be proved correct, but people ignore the bears because it takes so long. By then a lot of people have just stopped listening. I don’t know that they should not be ignoring it. The market tends to evaluate everything and attempts to put it in perspective. Sometimes they’re wrong -- like when it came to housing and the financial crisis -- and they might be ignoring it currently at their own peril later on.

That’s why I always think it’s wise to use both fundamental and technical analysis, since fundamentals tell you what and technicals tell you when. Right now the fundamentals are positive from a mainstream Gross Domestic Product perspective as well as a corporate earnings standpoint, but there are a lot of potential pitfalls from housing, unemployment, and debt that may yet materialize. Technically speaking, however, the trend is still our friend and implies further upside. Should these worries be moved from the back burner to the front burner once again, the charts will likely give us advanced warning.

H.L.: What sectors of the economy look healthy and which don’t?

S.S.: All sectors of the S&P 500 are expected to post positive year-over year results in the fourth quarter of 2010 as well as the full year of 2010 and in 2011. The strongest earnings increases in 2011 are likely to be seen in the cyclical areas of the economy, such as industrials, technology, energy, and materials.

The defensive areas, which are also typically slow-growth areas, are likely to be just that, the laggards in corporate profit growth this year.

H.L.: Will the dollar stay strong, and if so is that bad for stocks, the way it recently has been?

S.S.: The dollar may decline from a technical perspective in the near term as it undulates between support and resistance, yet should the U.S. economy continue to improve and interest rates gradually work their way higher, that would likely cause the dollar to remain firm rather than force it into a renewed downward direction. It’s neither good nor bad, because investors will look at the firmer dollar as a confirmation that our economy is improving.

H.L.: Now that the Republicans are in control of the House of Representatives, will their promises of massive spending cuts and elimination of business regulations end up killing the recovery?

S.S.: We believe that because the Democrats still control the Senate that we probably won’t see the steamrolling effect of the Republican-controlled House and its impact on spending cuts that people worry about materializing in 2011. They will still have to get a buy-in from the Democrats. So it may curtail increased spending, but it probably won’t lead to draconian spending cuts.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.