Jeff Clark’s note: As I’ve been writing in these pages, I think the stock market is ripe for a correction in the very near future. After reading Eric Fry’s latest column, I’m even more convinced a decline is around the corner. For his take on the market right now, read on...
Markets Make Delusions
By Eric Fry
December 15, 2006
Betting against a year-end stock market rally is a little like betting against tomorrow’s sunrise. Even so, we think this might be a bet worth taking... against a year-end stock market rally, that is.
It is a fact that year-end rallies arrive almost as reliably as the daily sunrise. Only 13 times in the last 78 years has the stock market fallen between December 13 and New Year’s Eve. In other words, it has rallied 83% of the time. That’s why the so-called “Santa Claus Rally” has become a canonized article of faith on Wall Street.
Everyone knows that it will arrive every year.
The year-end rally does not only arrive predictably, it also arrives powerfully. It seems to overcome whatever macro-economic obstacles stand in its path. Despite the ravages of the Great Depression, for example, and the traumas of the Second World War, the Santa Claus Rally arrived each and every year from December 1934 through 1953 – a 20-year span that delivered average year-end gains of 3%. More amazing still, the cumulative gains from these 20 year-end rallies totaled 86%, or more than half of the stock market’s total gains during this 20-year period.
We must remember, however, that these awe-inspiring statistics merely suggest probabilities. They do not guarantee anything. Last year, the stock market slipped 1.4% between December 13th and New Year’s. So could it not fall again this year? Sure, it could. But 73 years have passed since the last time the stock market stumbled during two consecutive year-end trading periods. In the back-to-back Depression years of 1932 and 1933, the stock market produced slim losses between December 13th and year-end.
But 2006 is not a Depression year... except for the short-sellers of emerging market stocks. 2006 is a celebration year. The housing market may be crumbling, Iraq may be imploding, the dollar may be collapsing, and the ice caps may be melting, but the stock market seems to celebrate it all. Since bottoming out at 10,706 on June 13, the Dow Jones Industrial Average has soared more than 1,600 points – or 15.2% – without ever pausing to enjoy the views on the way up.
Share prices have been rising for so many months now that most investors trust stocks to continue rising. It is common knowledge that stocks are a “buy.” Unfortunately, “common knowledge” might just be a polite phrase for “mass delusion.” Stocks are not always a “buy,” especially not when everyone knows they are.
“At the moment, investors are feeling extremely confident... maybe too confident,” we observed in the November 30th edition of the Rude Awakening. “...Investor sentiment has become too bullish for the market’s good.”
“To anticipate short-term market action,” we noted, “it sometimes pays to monitor the collective attitudes of investors. When they are feeling extremely pessimistic, stock market rallies often begin. And when they are feeling supremely confident and complacent, share prices tend to fall. At least, that’s the bedrock assumption that inspires 'contrarian investing.’”
Since highlighting extremes of bullish sentiment in our November 30 column, the Dow and the S&P 500 have gained slightly, while the Nasdaq and the Russell 2000 have dipped slightly. In short, the market has gone nowhere. But we think it’s about to go somewhere... like down.
Over the last two weeks, most measures of investor sentiment have become even more extreme. 59.8% of the investment advisors polled by Investors Intelligence are now bullish – that’s the highest bullish percentage of the year. By contrast, only 23.9% of advisors are bearish. In other words, bulls outnumber bears nearly three-to-one. That’s not a favorable omen for share prices. These latest readings stand in stark contrast to the downbeat sentiment readings of mid-June, when the bulls and bears were deadlocked at 35% apiece.
“Historically, bulls are 55% to 60% when indexes achieve record highs,” according to Mike Burke and John Gray, the editors of “Advisors Sentiment” from Investors Intelligence. “Those extreme levels of optimism often prove negative, as they reflect fully invested positions leaving little cash for additional purchases.”
The recent stretch of seven positive months for the Dow Jones Industrial Average is the longest monthly winning streak in more than 10 years. The stock market’s monthly, weekly and daily gains of the last seven months have not been particularly large, all totaled, but they have been amazingly steady. So it is little wonder that investors have become excessively optimistic. Seemingly effortless stock market gains have a way of lulling investors into a state of comfortable complacency.
“Days, weeks and months without meaningful losses can become psychologically empowering,” Burke and Gray explain, “prompting reckless investors to ‘lift the offers,’ thereby putting in a major top. We do not say that we have reached this point, but... there are any number of things to worry about here.”
In addition to the worrisome jump in bullish sentiment, Burke and Gray also note a “marked increase in insider selling.”
Heavy insider selling, extreme bullish sentiment, and frothy market action do not guarantee an imminent top in the stock market, but neither do they signal a low-risk buying opportunity.
Place your bets.
Eric Fry
Editor’s note: Eric Fry, the Rude Awakening’s editorial director, has been a specialist in international equities since the early 1980s. He was a professional portfolio manager for more than 10 years, specializing in international investment strategies and short-selling.
After his three-year tour of duty at the Daily Reckoning, Mr. Fry launched the sometimes abrasive, mostly entertaining, and always insightful Rude Awakening – “a hot cup of coffee in the face of Wall Street.” To sign up for a free subscription to the Rude Awakening, click here.
