Recent contrarian signs are raising the probability of more stock gains ahead, and they could be significant. Disclosure: Author is fully invested in U.S. growth stocks A surplus of warnings When do warnings about stock investing dangers become a bullish indicator? When they become widespread, noisy and based on tired, we-know-that-already rationale – especially, weak and simplistic reasoning. Earlier last week, the stock market news feed became 100% bearish, with heady warnings about the stock market being in a bubble, grossly overvalued and ripe for a drop, plummet or crash – “1987!” warns one. The proof? The same ol’ threesome: The abnormally steady stock rise, the extraordinarily high valuations and the widespread investor complacency. The italicized modifiers make all these reasons nonstarters. 1. The stock market’s rise is too calm The stock market is forever producing “abnormal” somethings that data geeks hunt for to concoct otherwise baseless relationships and forecasts. The number of up days and the low VIX level have been popular this time around. The problem is that “quiet” market periods – up, down and sideways – have been around since markets began. While they can produce views of “too quiet” and “ready to explode,” history reveals no consistent outcome. However, a contrarian outlook is possible when there is widespread agreement about a significant next move. Today’s broad-based worry about an approaching, significant decline is just such a time. 2. Stocks are overvalued This premise, now many months old, continues to gain followers: MarketWatch (July 21): “Two-thirds of U.S. investors think stocks are overvalued”
“About 36% of investment managers find the U.S. stock market undervalued or fairly valued at current levels, according to a quarterly investment manager survey performed by Northern Trust Asset Management. That’s the lowest reading in the history of the survey, which began in the third quarter of 2008.
“Nearly two-thirds of investors—65%—say the U.S. equity market is overvalued, the highest percentage on record.”
- “Goldman Sachs research highlighted “elevated valuation on almost every metric” in its weekly report on markets.
- “Goldman analysts say the forward P/E multiple of the S&P 500 has risen by 80 percent since 2011.
- “FactSet data indicates the trailing 12-month P/E ratio for the market is 22.1, well above the 10-year average of 16.7.”
The first problem is that “current” results (e.g., P/Es based on already reported earnings) are notoriously poor valuation measures. Future results (and their probability) underlie investment decision-making. The second problem is thinking that there are permanent levels that indicate over- and under-valuation. Goldman’s use of 2011 (when huge uncertainties existed) is a good example. Look farther back, particularly to “normal” growth stock periods, and the “extreme” 20x P/E measures of today look unremarkable. In fact, a stock with only an average P/E ratio raised doubts about the company being a true growth investment. In April, Bloomberg explained the best approach for thinking about this market’s valuations:
Bloomberg (April 21) “
Sure, Stocks Are Overvalued. Now What?”
“It’s no secret that U.S. stocks are overvalued. After eight consecutive years of gains — we’re now into the ninth — it would make sense that the S&P 500 Index would have above-average valuations based on almost every measure.
“Legitimate arguments can be made that U.S. stocks deserve these prices for many reasons, including low interest rates, low inflation, slower growth everywhere, higher profit margins, and a diverse and mature economy.
“The problem for investors is that stock market cycles don’t always follow the same pattern. No one really knows if we’re in the seventh-inning stretch, the bottom of the ninth, or heading into extra innings. They don’t ring a bell at the top and these things can go on for much longer than most investors imagine.”
3. Investors are complacent Investors complacent? Hardly. The worrywarts are in the majority. They just think they are in the minority, seeing the risks that others are ignoring and about to collect the prize from being contrarians and underweighting stocks until they are cheap. (By the way, this attitude exists among both individual and institutional investors and investment managers.) Another sign of how extreme this position has gotten is today’s (August 12)
Barron’s “Up and Down Wall Street” column by Randall Forsyth: “
The Curse of 2017: Stocks May Be Headed for a Fall”
“But even before the equity markets shuddered and volatility vaulted on Thursday in reaction to the rhetoric between Pyongyang and Washington…, stocks seemed precariously perched near their highs.”
“Precariously perched?” Attractive alliteration, but loaded labeling. Randall then attempts to bolster his view with an “everybody agrees” weighting, listing other known investors who also think stocks will drop. Finally, to spice up this bland offering, he adds a sense of unease by inserting this subtitle at the top of is article: “Since 1887, in years ending in 7, the market has swooned around this time of year. Is history repeating?” Disguised as a history lesson, this observation is exactly the kind of data geek logic that is baseless and can both misinform and upset investors.
And now this: A positive view with sound reasoning A regular feature worth reading is “Heard on the Street” in
The Wall Street Journal. It often contains valuable kernels of fact and insight. This Thursday (August 10), Richard Barley concluded the section with a succinct, 352-word piece: “
Ten Years On, the Crisis Still Looms Large.” His subtitle: “Fear of renewed trouble has never been far away since August 2007.” Richard explains why the current stock market trepidation exists and how that means we can relax and be bullish. (Underlining is mine.)
“The financial crisis still looms large in market psychology. The prevailing tone is one of worry about the high level of asset prices, concern about the low level of volatility and a fear of complacency: rising markets are a source of angst, not euphoria. But this persistent concern may yet be a positive factor, by helping to prevent markets from becoming too reckless. Low market volatility may simply reflect low economic volatility. BlackRock notes low-market-volatility regimes can last for years and have accompanied sustained economic expansions.
“Undoubtedly, a shock will occur at some point. Geopolitical tensions over North Korea are just the latest focus. China’s reliance on debt, persistent vulnerabilities in the eurozone, the removal of monetary stimulus and populist politics are all on the watch list. But the real time to worry should be when no one is worried. Ten years on from August 2007, that day has yet to arrive.”
Those underlined items are key. First, he explains why this stock market period is the antithesis of a bubble. (When optimism reigns, concerns are ignored and price rises are viewed as positive proof of more to come.) Second, he underscores the first point’s meaning as giving the thumbs up to owning stocks now and worrying later when conditions warrant.
The bottom line Today’s stock market, while trading near its highs, exhibits calm and steadfastness. Yes, it has steadily risen without a significant drop for a while, And, yes, valuations based on known earnings are higher than when stock prices were lower. And, yes, a lack of concerns can produce complacency. However, this market is filled with concerns – its calm rise, higher valuations and the supposed complacency of others. Therefore, there is no bubble to pop. Instead, this circular reasoning, itself, appears to have reached a new high level. If so,
that may be the trend that breaks, sending a flood of cash to stocks.
But what about…? I realize I have presented no tables, graphs or other supporting data. The reason is that contrarian investing opportunities are dependent primarily on conditions, beliefs and popularity readings. Too much of a good thing can produce those overinflated bubbles. Too much a bad thing can produce opportunities from dismay-laden selloffs. In between, bouts of doubt (like now), favoritism and neglect can generate added returns from adopting a contrary strategy.