Why the New Bearishness Is Good for Stocks

In my last column, I explained why stock returns over the next decade are likely to be far less than returns over the last decade: high valuations.

At the market bottom in 2009, stocks sold at single-digit price-to-earnings ratios and yielded more than 6%.

Since then, large cap stocks have more than quadrupled. Small cap stocks have more than quintupled.

Today, the S&P 500 sells for 25 times earnings and yields less than 2%.

If history is any guide, returns over the next several years will be less than the market’s long-term historical average of 10% a year.

Yet these metrics tell us nothing about what the market will do in the near term.

After all, over a period of years, stocks routinely fluctuate between extremes of undervaluation and overvaluation.

Stocks were inexpensive. Now they’re not.

But they could easily get more expensive before they get cheaper.

In fact, one factor indicates they have higher to go: investor sentiment.

It’s turned negative lately. And that’s a good thing for those of us on the long side of the market.

Investors are worried that the Fed will take interest rates too high, too fast.

They are concerned about the possibility of a trade war between the U.S. and China.

And they are alarmed that the tense geopolitical situation in Syria could get worse and perhaps even engulf the Middle East, sending oil prices higher and stocks lower.

That’s aside from the everyday concerns like higher energy prices, greater stock market volatility and an economy that – eight years after the Great Recession – still hasn’t shifted into third gear.

The CBOE Volatility Index – better known as “the VIX” – is Wall Street’s fear gauge. It is up 95% in 2018.

According to FactSet, investors have redeemed a net $25 billion from the popular SPDR S&P 500 ETF so far this year.

In fact, U.S. stock funds haven’t had net retail inflows for any week since the end of 2017, according to fund tracker EPFR Global.

Even the pros are down on stocks.

The National Association of Active Investment Managers Exposure Index, a measure of active money managers’ exposure to U.S. equities, recently fell to 49.4, down from an average of 78 in the first quarter and an average of 63 over the last 12 years.

It was 121 just four months ago.

You might think that people getting fearful, turning bearish and cashing in their stocks is a negative for the market.

But it’s not. History shows that increasing bearishness is highly correlated with rising stock prices.

Negative sentiment shakes out the weak hands as they dump stocks to run to cash.

With the “Nervous Nellies” out of the way, fresh buying generally takes share prices higher.

It’s a contrary indicator – and a good one.

A negative one would be just the opposite.

For example, when investors are convinced that an uptrend will continue – sure that “the sky is the limit” – it’s a dangerous sign.

You could see it when people were flipping condos 10 years ago – or flipping internet stocks two decades ago.

Don’t get me wrong. Sentiment isn’t anywhere near as negative now as it was nine years ago.

But bull markets climb a wall of worry. There is plenty of fear and anxiety in the market right now.

And that’s an excellent signal that stocks have further to run.

Good investing,

Alex