Market Outlook: September 15, 2003(A)

Back in January we stuck our neck out and said we believed the bear market had reached its low last October. When stocks then plunged in March, threatening to revisit those October lows, we’ll admit we were sweating. Bearishness in both word and deed was rampant as any memory of making money in stocks was by then more than three years old.
When the March decline bottomed out at levels north of those reached last October it strengthened our conviction that the epic bear market was over. Fast forward to today and the S&P 500 is up 33% from those October lows while the tech-heavy NASDAQ is up 69%. Suddenly we have a lot more company in our bullish camp, a fact that we’d usually find disconcerting.
For, indeed, many sentiment surveys that register what investors are saying about the stock market show very high levels of bullishness. This has led many pundits to warn that with stocks posting such large percentage increases in such a short time and with bullish attitudes so prevalent the current rally in stocks is surely soon to end.
We don’t believe it. We do expect pullbacks and consolidations as part of the process of the market moving higher. But move higher we believe it will.
There are several reasons for our bullishness. One is that we are only now getting our first taste of resumption in capital spending. This is the crucial and long-awaited piece of the economic puzzle. Capital spending acts like a booster rocket on the economy and the tepid pace of the recovery so far attests to its absence.
As this booster rocket kicks in, manufacturing activity should pick up, as should employment–finally. This last will in turn stimulate further demand in the economy, thus necessitating more manufacturing and employment, etc. This virtuous cycle is the exact reversal of the vicious cycle that drove the recent recession.
Secondly, this pickup in economic activity will boost profit and revenue growth at US corporations. As recent reports of soaring productivity attest, corporations have slashed their cost structures to the bone, which means they are powerfully leveraged to any increase in demand. So we think both the economy and corporate profits will surprise with better-than-expected news.
Thirdly, given the prevailing inflation and interest rate environment, the S&P 500 is still undervalued, even after rising 33% off its lows. If earnings continue to build as we expect, stock valuations will not stand in the way of the market rising higher.
Finally, we’re very encouraged by what we see as an atypical divergence in investor sentiment. What investors are saying about the market is fairly bullish and normally that would serve as a good proxy for what they’re actually doing in the market. But these are not normal times. We are coming out of the worst bear market in three decades and at present investors’ actions are speaking more loudly than their words.
In our last commentary we shared a chart from BCA Research showing the “Cash Mountain” that investors have accumulated, a record-high level of cash, in fact, when viewed relative to the total value of all stocks traded in the US. That is as strong an indication of investor fear and skepticism as you could ask for.
Now word comes that another indicator of investor pessimism has reached record-high levels, namely, the outstanding short interest on NASDAQ-listed stocks. Short interest is the dollar value of bets made by investors that a stock or stocks will fall in price. As the NASDAQ has risen off its extremely depressed base in recent months the short interest on these same stocks has soared to record levels.
Mountains of cash and record-high short interest do not indicate high investor confidence. In fact, just the opposite. We continue to believe that the majority of investors doubt the rally in stocks as well as the recovery both in the economy and corporate profits. This is natural and to be expected after the multi-dimensional trauma of the past three years. As that doubt is converted to belief—by an improving economy, rising profits and climbing stock prices—demand for stocks will increase, causing stocks to rise further.
In closing we should say that our bullishness isn’t rooted in ignorance or naivete. We are well aware of all the things that could (or are) go(ing) wrong. But so is everyone else. Our optimism is rather an expression of our contrarian belief that it pays to bet against the herd, particularly when the herd has already stampeded in one direction or the other. Today the herd today is still out of stocks. We think that will change.