Nothing to Fear but LACK of Fear Itself
The market is enjoying incredible momentum, buoyed by the Federal Reserve’s $600 billion quantitative easing program (“QE2” is the popular Wall Street name), the hopes of less anti-business rhetoric with the Republican victory in the house, and the Bush tax cuts extension. All of these reasons have created expectations for a solid recovery and the belief that the prospects of a double-dip recession are obsolete. The only fear that seems to prevail is fear of missing the bandwagon as the market surges onward.
In the December 13, 2010 Barron’s, Alan Abelson wrote an article titled “Everyone’s Bullish and That’s Bearish.” Time and time again, investor sentiment proves to serve as a contrary indicator at the extremes. He wrote, “According to the latest tally of advisory services by Investors Intelligence, 56.2% were bullish… not that far below the October 2007 high of 62%, just before the market went into its deadly tailspin. It also contrasts strikingly with the prevailing pessimism at the end of August [which was precisely when the rally resumed], when the number of bulls had shrunk to 29.4%.” Warren Buffet has said, “You pay a very high price in the stock market for a cheery consensus.”
Alan also points out that speculative activity has increased with margin debt surpassing $300 billion. In March 2000, margin debt reached $299.9 billion, and one year later markets were down 22.6%. The market later declined again by 22% after surpassing the $300 billion margin debt threshold in December 2006. The last time the margin balance reached these levels was in September 2008, just before the Lehman collapse where the market took a nose dive as a result. There is no doubt in our minds that investors have returned to their speculative behavior. We are not predicting a 22% drop one year from now, but quoting Mark Twain, “History doesn’t [necessarily] repeat itself, but it does rhyme.”
Another signal is the volatility index (VIX), known as the “fear gauge,” which tends to have an inverse relationship to stock prices, has dropped down to low levels not seen since the last time the market pulled back in April. Lastly, short interest, or the number of shares sold short in the market, is at its lowest level this year, signaling more and more investors are joining the chorus that the market will continue to climb. The question “is the glass half full or half empty” has transformed into the belief that the glass is completely flowing over. With this song being sung so intensely in unison, it could just shatter the glass altogether.
One year ago we noted in our year-end letter that when the 2008 forecasts were made, every single Barron’s 2008 forecast predicted an up year ranging from 3% to 18%, when in actuality it turned out to be a negative 37%! This year, there’s a similar feel amongst market forecasters, with most on Wall Street predicting a 10% to 15% return. We are not claiming that this year will be a repeat of failed forecasts, but we will admit it does feel akin to déjà vu.
What will be the catalyst to shake the markets? Any number of things could trigger a reversal – surging commodity prices, rising interest rates as the U.S. deficit soars higher, a continued slide in home prices, more developments in the European sovereign debt crisis (Greece, Ireland, is Portugal next?), state fiscal debt troubles expanding which lead to more budget cuts (the next biggest contributor to GDP behind the consumer), underemployment worsening, to name a few.
We do not claim to be clairvoyant, but we do know we can be prepared by sticking to our strategy. At the end of the day, what will impact the value of your portfolio are the specific companies you own.
Disclaimer: The specific securities identified and discussed should not be considered a recommendation to purchase or sell any particular security. Rather, this commentary is presented solely for the purpose of illustrating YCG’s investment approach. These commentaries contain our views and opinions at the time such commentaries were written and are subject to change thereafter. The securities discussed do not represent an account’s entire portfolio and in the aggregate may represent only a small percentage of an account’s portfolio holdings. These commentaries may include “forward looking statements” which may or may not be accurate in the long-term. It should not be assumed that any of the securities transactions or holdings discussed were or will prove to be profitable. Past performance is no guarantee of future results.