Market Outlook: October 1, 2003(A)

Investor Sentiment: Bullish in Word, Bearish in Deed
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 profits from 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 28% from those October lows while the tech-heavy NASDAQ is up 60%. Suddenly we have a lot more company in our bullish camp, a fact that we’d usually find disconcerting.
For, indeed, 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 stock must be nearing its 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.
Fundamental Grounds for Optimism
There are several reasons for our bullishness. One is that we are only now seeing a recovery in capital spending. This is the crucial and long-awaited piece of the economic puzzle, as has been noted in past commentaries. 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. 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.
We’ll note that the bears are making much of the fact that this recovery has yet to produce much in the way of new jobs. This lack is said to be the harbinger of a stalling economy and stock market in ’04. We would remind the storm crows that following recessions over the past 40 years the median amount of time between an upturn in the stock market and an upturn in the job market is 14 months (the shortest period was eight months, the longest 18). If you mark the market bottom at October 9, 2002 we are now at 12 months. So there’s nothing unusual about the “joblessness” of this current recovery. Employment is always the last piece to fall into place and this time will be no different.
The acceleration in economic activity we expect will in turn 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 good news. Given the inflation and interest rate environment, the market is still undervalued, even after this rally. If earnings continue to build as we predict, stock valuations will not stand in the way of higher stock prices.
For a True Gauge of Investor Sentiment “Follow the Money”
Finally, we’re encouraged by an atypical yet striking divergence in investor sentiment. What investors are saying about the market is 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 compared to the value of all stocks traded in the US. That is as strong an indication of investor 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. Just the opposite. We believe the majority of investors doubt the rally in stocks, doubt the recovery in the economy and doubt the resurgence in corporate profits. This is natural after the manifold traumas of the past three years. But as that doubt is converted to belief—by an improving economy, rising profits and climbing stock prices—demand for stocks will increase, causing stock prices to rise further.
We are aware of all the things that could go wrong. Our optimism is based not on naivete but on 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.