Sentiment Driving Prices Higher: Bull Is in Full Stampede Mode

by: Sean Hannon

Broadly speaking, three different factors drive stock prices. Firstly, the macro environment as portrayed via the economy has great influence over the direction of prices. When the economy is robust and inflation low, such growth leads to higher prices. Currently, such an economic backdrop does not exist. Although I agree that the recession is nearing completion, growth will not quickly resume. Unfortunately, I believe that our economy has been forever altered as consumer behaviors will change (i.e., more savings, less consumption) and entire sectors have been curtailed (i.e., lack of leverage means fewer jobs in prime brokerage).

Secondly, prices react to company-specific valuations. Again, this metric is not particularly supportive of stock prices. The Value Line median estimate of price-earnings (PE) ratios stands at 15.9 versus 11.1 six months ago and 10.3 when the market bottomed on March 9.

Finally, stock prices react to investor emotions. Under this metric, the bull is now in full stampede mode. One of my favorite methods of gauging investors' emotions is to examine a broad array of market indices. When price movements confirm one another, it indicates a prevailing trend. Recently, that trend has been straight up.

Over the past two days, ten of the eleven markets I follow have reached new highs. As the bulls pull everyone higher, we should expect the trend to continue and trade accordingly. Taking contrarian positions often leads to outperformance, but trading against powerful trends ensures losses. With prices continually moving to the upside, we must remain mindful of this primary trend while also managing our risk position carefully. After all, trading with the trend increases the odds of success, but recklessly chasing that trend guarantees failure.