The Dow Jones industrial average on Thursday is on track for a third straight record high after breaking above its 2007 high on Tuesday, ratcheting up the urgency over what the rest of the year is going to look like. Has the market gone too far too fast, or is the breakout into record-high territory a setup for bigger gains ahead as investors join the rally?
Richard Bernstein (via Pragmatic Capitalism), who has expressed reservations about stocks during the technology bubble and housing crisis, remains enthusiastic about stocks. He argues that there are three classic signs of an oncoming bear market, and none are evident today.
1. The Federal Reserve tightens too much. According to Mr. Bernstein, bull markets don’t end with rate increases, but rather when the Fed raises rates too much. Yet, the Fed has made it clear that rates will remain low for some time.
2. Significant overvaluation. This is up for debate. Stock prices look reasonable based on trailing earnings, and expensive based on 10-year average earnings. But Mr. Bernstein prefers to look at valuation from the perspective of investors’ certainty: When investors are certain about the market, it is probably overvalued – and right now he believes there is “great uncertainty surrounding the U.S. equity market.”
3. Euphoria. Within the U.S. equity market, Wall Street strategists are recommending relatively low equity allocation, pension funds have low equity allocation, and mutual funds have only recently begun to attract inflows. Ergo, no euphoria.
Still, the stock market does inspire some head scratching. Bespoke Investment Group has an interesting chart, comparing bullishness among small investors with the S&P 500. The broad index, of course, is moving toward a record-high of its own, yet the latest weekly survey from the American Association of Individual Investors shows that bullish sentiment stands at just 31.1. That’s up slightly from the previous week, but well below average.
“In many ways, the shifts in sentiment over the last two weeks are emblematic of the entire bull market,” Bespoke said. “Investors have been slow to embrace equities, and even after they commit, they already have one foot out the door.”
Mr. Bernstein might argue that this lack of bullish sentiment among small investors confirms his belief that stocks remain undervalued – but you do have to wonder if money is going to remain on sidelines rather than flow into stocks and push the bull market to new heights.
Meanwhile, there is plenty of skepticism about stocks. The Wall Street Journal provided some anecdotal evidence that many hedge funds are selling.
And Barry Ritholtz at The Big Picture pointed out that Lakshman Achuthan of the Economic Cycle Research Institute is sticking to his view that nominal economic growth is below “stall speed” – suggesting that the stock market is merely rising into a recession.
Mr. Ritholtz believes that this might not be such a big deal. As he explains, “this hardly matters for equities. In fact, markets correct before official recessions, primarily because contractions typically show up in earnings long before they do in the economic data.”