Understand True "Excessive Bearishness"

Includes: DIA, QQQ, SPY
by: Smart Guy Stocks

Contrarian indicators work. When investors become overly fearful, stocks become undervalued. When investors become overly greedy, stocks become overvalued. However, recently I noticed a little game that permabulls play: like the boy who cried wolf, they start screaming “too many bears!” when the market is less than 10% lower than all-time highs. This tactic is supposed to make the average investor believe we’ve hit bottom and it’s time to start bargain hunting.

Consequently, the market stages lower volume mini rallies where smart money continues to sell to the naive and we witness the bearish phenomenon of lower highs and lower lows. When these declarations of excessive bearishness are not confirmed by a bear market or stocks trading far below historical valuations, these false cries signal continuing excessive bullishness.

During the past couple months I have heard about excessive bearishness on CNBC, Kudlow & Co., in Barron’s, and from notable permabulls Jeremy Siegel and game show host-turned-analyst Ben Stein. With the exception of Barron’s, these information sources have dished out plenty of recommendations to buy homebuilders and banks as both sectors have tumbled like a four year old at the Little Gym. For both builders and banks, since the beginning of each downfall, these bullish sources have continued to cry “excessive bearishness” as the reason to start buying. Evidently, they have been very wrong.

However, the permabulls have failed to note that true excessive bearishness is not a mere 10% pullback from all-time highs amidst a five-year bull market. True excessive bearishness is the kind touted by every “How to Invest like Warren Buffett” book (i.e., half the investing books at your local bookstore). True excessive bearishness is what bear markets are made of. We will know when bearishness becomes excessive because you will find the best companies selling at excessive discounts to value – and I do not mean a couple points below the long term average for price to earnings, or a great home builder with 24 months of supply on the books.

I agree that after the housing market decline and credit crunch we have heard more bearish voices percolate to center stage. Although we are seeing more bears now relative to bears in the past five years, we are far from seeing the bull-bear ratio reach levels where the market has massively undervalued stocks and has pushed permabulls into hibernation.

I also agree that financials, homebuilders, consumer discretionaries, and other related industries have been hit hard. However, the major indices have held up very well. Thus, we have not seen the quintessential excessive bearishness that spreads to all industries and sectors regardless of underlying fundamentals. True excessive bearishness is not simply when hedge funds use puts or shorts as insurance. True excessive bearishness is when everyone sells everything based on intensifying fear. Although some people act as though the last recession was 100 years ago, I have tapped into my long-term memory to access files of excellent companies falling far below intrinsic value in 2001. That was true excessive bearishness.

Given that there are tons of bulls keeping the market close to all-time highs, we have not experienced true excessive bearishness — no matter what the pundits say. Until you see stocks getting excessively punished and the indices reflecting excessive fear, there is still no wolf from which we must be saved.

Disclosure: SmartGuyDH wishes the free market would let equity valuations readjust so we could start going long again.