With U.S. stock prices high and the globe unsettled,
investors are feeling unusually anxious. Paradoxically, that could be a fine
thing for markets. Historically, markets typically fall apart when euphoria
leads to reckless investing, as before the collapses of 2000 and 2008. It is
less common for markets to fall hard when investors are acting cautiously.
Anxiety levels have grown since the spring of 2013, when the
Federal Reserve indicated it would trim the stimulus that has supported markets
since 2008. The Dow is up 154% from its March 2009 low.
Professional investors such as pension funds, insurance
companies and hedge funds have reduced stock ownership since the spring of
2013, according to government data. Investors have shifted toward Treasury
bonds. The 10-year U.S. Treasury note Wednesday yielded just 2.41%, its
lowest level in more than a year. Money managers are sending clients reports
discussing whether stocks are in a bubble. To protect themselves from declines,
people are buying options at higher rates than at any time this year.
Merrill's strongest indicator in this domain is one it has
been tracking since 1984. When this indicator has been at its current level, stocks
have risen 98% of the time. The indicator is based on the advice offered by
Wall Street strategists. When investment strategists are very bullish, it
typically is a sign of excess optimism. Stocks generally do poorly then. When
strategists are very bearish, stocks usually do well.
Wall Street strategists today are bearish. They recommend
that investors hold just 51% of their money in stocks, far below the average
recommendation of 60% over the past 15 years. That is well below the peak of
66% before stocks started to crumble in 2007. For Merrill, any average
recommendation below 54% is a buy signal. This indicator currently forecasts a
22% stock gain in the next 12 months.
Merrill also tracks the exuberance of money managers, who
also are bearish. Its surveys show money managers holding 5% of assets in cash,
the most since June 2012. That is up from 4.5% a month ago. Mutual-fund data, meanwhile,
indicate the same pessimism. Mutual-fund holdings of stocks whose performance
depends on strong economic growth are the lowest since 2009, Merrill said.
Despite all the signs of nervousness, there still is excess
in parts of the market, such as social-media stocks, biotechnology stocks and
junk bonds. Surveys of futures traders and newsletter writers suggest that some
investors still are overly optimistic. If they panic, their selling could hurt
the broad market.
Others worry about valuations being above their long-run
average and point to signs of complacency. The fear gauge known as the CBOE
Volatility Index, or VIX, was at 13 on Wednesday, well below its long-run
average of 20. The current bull market was fourth-longest on record at 1,982
days.
The most likely scenario is that U.S. stocks will grind
slowly higher, the risk of a decline greater than the likelihood of a big gain.
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